Congress is considering a bill requiring the Federal Reserve to adopt a mathematical rule, such as the “Taylor Rule,” for determining monetary policy. More about the Taylor Rule later in this column, but on balance, this is a bad idea.
Yes, many respected economists support the general proposition that a central bank like the Fed should follow “rules” rather than “discretion.” And yes, the Fed erred badly in the decade leading up to the economic debacle that unfolded in 2008, as it did in the 1970s. Criticism of past policies is deserved. But that still doesn’t mean this legislation is a good idea.
The issue goes back to a debate started by Chicago economist and Nobel laureate Milton Friedman a half-century ago over whether a central bank should be able to depend entirely on the subjective discretion of its leaders — or whether those leaders should follow specific objective criteria, a sort of “monetary rule,” to determine the money supply and hence interest rates.
Friedman himself preferred a simple rule of letting the money supply grow at the same rate as the long-term growth rate of the economy itself, as measured by Gross Domestic Product. He repeatedly noted, most famously in his Nobel acceptance lecture, that we would not need a Federal Reserve chairman or a panel like the Fed’s policy-making Federal Open-Market Committee to make monetary decisions. A computer, “in the basement of the Fed,” could digest new economic statistics and issue orders.
Up through the 1970s, the Fed tacitly followed a policy of targeting “nominal” short-term interest rates. Nominal means “without any adjustment for inflation.” Blindly following that policy led to inflation that tripled the Consumer Price Index between 1967 and 1982.
In 1979, when President Jimmy Carter appointed Paul Volcker to head the Fed, that supposedly changed. Volcker was a monetarist like Friedman, albeit a moderate and pragmatic one. The Fed ostensibly adopted a policy of targeting growth of the money supply. But, for a variety of reasons, that proved harder in practice than in Friedman’s abstract theory. In practical terms the Fed under Volcker exercised discretion just as before. It just followed a much tighter policy than under previous chairmen. This led to sky-high interest rates from late 1979 until the mid-1980s. It also got rid of inflation.
Ronald Reagan’s staffers thought Volcker’s policy far too tight and tried to force him from office. When Volcker quit in 1987, Treasury Secretary James Baker called White House Chief of Staff Howard Baker to crow, “We got the son of a bitch.”
However, Volcker’s successor, Alan Greenspan, didn’t change much at first. He was as much of a monetarist as Volcker and a much more ideological one. A tight money policy in the first years of Greenspan’s tenure contributed to the 1990-91 recession that torpedoed George H.W. Bush’s re-election. Bush was well justified in his complaint that, “I reappointed him and he disappointed me.”
But Greenspan, the tight-money monetarist in the first several years of his tenure, became an easy-money, seat-of-the-pants discretionist in his last decade. From 1996 to 2006, the money supply grew at twice the rate of inflation. That violated Friedman’s warning that such a policy leads to inflation. And after 2001, short term interest rates were pushed below the rate of inflation and held at levels well below the averages of the prior 60 years.
The Fed is very defensive about its role in inflating the real estate and financial asset bubbles that popped after mid-2007, but history will be harsh. Yes, there was no undue inflation in consumer prices. But there was an unsustainable run-up in asset prices and the outcome was highly damaging.
Now for the aforementioned Taylor Rule. Proposed by Stanford economist John B. Taylor in 1993, the rule says that a central bank should use a formula to target short term interest rates based on inflation relative to some acceptable level and on GDP growth relative to its long-term potential.
The Wikipedia entry on the Taylor Rule details the complex mathematical formula, but the gist is that for a growing economy, with each percentage point that inflation goes up, short term interest rates should rise by 1.5 points. If the economy is shrinking, rates should drop by 0.5 point for each percentage point drop in GDP output.
Taylor is a Republican who served as No. 2 at the Treasury Department under President George W. Bush. He is a moderately conservative economist. But this rule is explicitly Keynesian (an approach not popular in the contemporary GOP) arguing that monetary policy deliberately should be jockeyed to counteract economic fluctuations. This is anathema to many Republican politicians.
If his rule had been followed by the Fed over the past 40 years, it probably would have avoided much of the inflation of the 1970s and some of the asset bubble after 2000. It also would require higher rates right now.
So why not write it into law?
The answer is that a central bank’s primary function is to act as a lender of last resort in times of financial crisis. That is a lesson from centuries of history. To do so it needs broad autonomy to act as needed. While following a rule in ordinary times may well be good policy, being shackled by that policy in times of crisis would be disastrous.
The proposed legislation does contain some escape clauses. But that only emphasizes the cynical trade-off in any law specifying what a central bank must do. Write it too narrowly and the bank is unable to deal with emergencies. Write it too broadly, with too many exceptions and escape clauses, and it becomes meaningless feel-good legislation. The bill under consideration in the House already errs in that direction, being larded with requirements that the government “audit” monetary policy if the Fed fails to comply. Exactly what such an audit would consist of is unclear to everyone, but it must have a nice ring to some in the electorate.
Yes , the Fed still has egg on its face from the run-up to 2007. Yes, the jury is still out on successive rounds of “quantitative easing.” But this bill is still a bad idea.