Rules for the Fed to Live By
This article originally appeared in U.S. News & World Report.
Should the Federal Reserve conduct monetary policy using a monetary policy rule? This question, a classic one in economics, was raised again during Chair Janet Yellen’s recent Congressional testimony and has become the subject of intense debate since then.
To some, the proposal to establish a rule is an attack on Fed independence, or a narrow-minded attempt to impose a straight jacket on monetary policy, but that is a caricature. Advocates of rules are not proposing rigid restrictions on Fed actions, but rather are insisting that the Fed spell out an empirically defensible framework that guides it, and explain deviations from that framework.
Critics see a Fed today that is adrift without a framework that defines how monetary policy weighs information to achieve the Fed’s dual mandate to stabilize inflation while promoting employment. Fed officials are sometimes incoherent in their analysis – for example, arguing, contrary to clear empirical evidence, that wage growth is a reliable indicator of inflationary pressure. Their remarks can be a source of market confusion, as shown in “the taper tantrum” of 2013 and more recently by the gap that separates Fed forecasts of interest rates from those observed in futures markets.
The lack of an articulated monetary policy framework also makes it difficult to hold the Fed accountable for deviations from sensible policy. Historians of the Fed have shown that such deviations have been the rule rather than the exception over the past century. Clearly, establishing a framework that would encourage coherent thinking, transparent communications and accountable actions is attractive. What are the potential costs of doing so? What adverse consequences might result?
A monetary rule simply links the Fed’s interest rate target to observable variables, such as the rates of inflation and unemployment. That simple formula summarizes succinctly the broader strategy the Fed would use to achieve its statutory dual mandate. By calibrating its rule using data to match current policy actions to successful policy actions in past periods, the Fed will helpfully guide and constrain itself.
The existence of a rule does not require slavish adherence to its prescriptions. The interest rate suggested by the rule becomes a benchmark. Policymakers would sometimes find it necessary to deviate from that benchmark. But when doing so, the rule would oblige them to explain why, both to the public and to Congress. In this way, the Fed would reassure observers that its strategy remains intact and that is acting to achieve its long-standing goals.
Critics argue that commitment to a rule would compromise Fed independence. In fact, it would do just the opposite, strengthening the Fed’s ability to withstand myopic political pressures. Once the Fed announces its preferred rule, either the Fed would follow its prescription or deviate and explain (under a presumptive burden of skepticism) why the rule should be put aside. There would be little room for the acrimony that has poisoned recent debates. The focus would be on economic issues. The Fed would point to the rule when explaining its unwillingness to behave myopically to members of Congress or the administration who might encourage it to do so.
What would a rule imply for monetary policy today? Under all current proposals, the Fed would be free to design a rule of its own choosing. But one rule that has already been subjected to extensive scrutiny and testing is the famous “Taylor Rule,” named after Stanford economist John Taylor. It currently prescribes setting short-term rates at about 1.25 percent, versus their current level very close to zero. With reference to the Taylor Rule, therefore, the Fed could make clear that the very modest interest rate increases being contemplated for later this year would still leave monetary policy highly accommodative.
Higher interest rates are not intended to choke off the economic recovery. They are only meant to bring monetary policy more in line with what is normal, based on experience from the past, and thus prevent inflation from rising above target down the road, thereby setting the stage for a prolonged period of economic growth and prosperity.
Charles W. Calomiris is a member of the Shadow Open Market Committee and the Henry Kaufman Professor of Financial Institutions at Columbia University. Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee.
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