The Financial CHOICE Act of 2017, just passed by the U.S. House of Representatives and now being considered by the Senate, incorporates plans for Federal Reserve oversight and reform appearing originally in the 2015 FORM Act. As we have written previously, this proposed legislation would require the Fed to adopt a specific, “Directive Policy Rule” for its conduct of monetary policy. The legislation also includes a “Reference Policy Rule,” which has the same form as the famous rule proposed by John Taylor in 1993. The intent seems to be the creation of a format by which values for the funds rate generated by the Congressionally-mandated Taylor Rule can be compared against those generated by the Fed’s yet unknown rule. If the two values diverge in important ways, the legislation would require the Fed to explain why.
From one perspective, the proposed legislation usefully constrains the Fed’s ability to take discretionary actions or pursue goals that are not part of its “dual mandate” for maximum employment and stable prices. Requiring the Fed to adopt an explicit rule also would promote transparency so that the public could monitor the Fed more easily. More subtly, however, the introduction of the parallel Reference Rule has the potential to increase uncertainty about monetary policy and undermine the Fed’s independence. In light of these potential problems, Congress should reconsider the value of a Reference Rule.
To appreciate how these problems could arise, recall that the original, 1993 version of the Taylor Rule can be expressed as
f = p + 0.5y + 0.5(p-2) + 2,
where f is the federal funds rate, y is the output gap, defined as the percentage deviation of real GDP from potential, and p is the inflation rate over the previous four quarters. Now assume, for example, the Fed chooses as its Directive Policy Rule the 1999 version of the Taylor Rule, which can be expressed as
f = p + y + 0.5(p-2) + 2,
and differs from the Reference Rule only by attaching a higher coefficient to the output gap. The implications of these two rules are shown in the figure below, which uses the price index for personal consumption expenditures to measure inflation and the Congressional Budget Office’s estimate of potential output to compute the output gap.
The figure indicates substantial differences between the prescriptions of the two rules over an extended period that starts with the financial crisis of 2008 and continues until quite recently. The original Taylor Rule, for instance, would have brought the federal funds rate back above zero at the end of 2009, whereas the 1999 variant would have delayed that lift-off until mid-2011. At times, the gap between the rates suggested by the two rules has exceeded 1 1/4 percentage points. However, because there is no consensus on the “best” form of such a rule, it is not clear which rule would have delivered better economic performance.
This comparison illustrates how use of a Reference Rule by Congress has the potential to introduce back into the monetary policymaking process exactly the kind of ambiguity and uncertainty that the adoption of a policy rule is designed to overcome. For whenever the Reference Rule generates values for the funds rate that diverge from those calculated by the Fed’s rule, market participants will speculate whether the Fed will take actions that bring the two values closer together or whether the Fed will continue to follow the implications of its own rule. And if the Fed does act to bring the two values closer together, observers will wonder if the Fed has lost some of its independence, with Congress exercising at least some control over the conduct of monetary policy. Because Congress only needs to monitor whether the observed value of the funds rate differs in meaningful ways from the value implied by the Fed’s rule to exercise its oversight responsibilities, the addition of a Reference Rule adds no useful information about the Fed’s past decisions but does introduce uncertainty about the future course of monetary policy. For these reasons Congress should reconsider the value of a Reference Rule.
The graph also hints at a more subtle reason why Congress might have incorporated a Reference Rule into the CHOICE Act. The original Taylor Rule prescribes higher interest rates during a recession, and is therefore more tightly focused on the Fed’s control over inflation than on its countercyclical objectives. But if Congress wishes to replace the Fed’s current, dual mandate with one that recognizes price stability as the principal aim of monetary policy, it should do so more explicitly and directly. The Fed’s own choice of a rule would then be shaped by its new mandate. Monetary policy would improve in two ways: by becoming more systematic and by focusing more specifically on achieving and maintaining price stability.
Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee. Michael Belongia is a professor of economics at the University of Mississippi.
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