Three Recommendations for Monetary Policy Compromise

Even though Federal Reserve Chair Janet Yellen is scheduled to testify before the Senate on Valentine’s Day, and in front of the House Financial Services Committee the following day, it seems unlikely that love will be in the air. It could be though, with just a few reforms. 

The easiest way to ensure that happens is for Congress and the Federal Reserve to cooperate on three relatively simple reforms to improve transparency and accountability in monetary policy, which don’t sacrifice the independence of the Fed. First, the Fed could voluntarily begin incorporating a version of the key component of H.R. 3189, otherwise known as the FORM Act. Second, the Fed could embrace a productive form of retrospective review. Finally, the Fed could expand its research capacity to include GDP futures markets.

The FORM Act’s provision (later incorporated into H.R. 5983, the Financial CHOICE Act) that would require the Fed to communicate existing monetary policy in terms of an existing rule (such as the ‘Taylor Rule’) has been a point of significant contention, but doesn’t need to be. As we’ve argued previously, communicating monetary policy in terms that members of Congress are familiar with could be extremely beneficial.

If the Fed is worried about being required to follow a policy rule, it could incorporate explanations of its decisions in terms of several pre-defined rules in the semi-annual report it already makes to Congress. In addition to the Taylor Rule, why not include a brief explanation of how monetary decisions depart from a simple inflation target or nominal GDP targeting?

Importantly, this step is relatively costless for the Fed. As Rep. Bill Huizenga (R-Mich.) noted recently, “They are already doing the analysis, so maybe it's asking them to share that analysis.”

Similarly, incorporating a retrospective review component keeps the monetary policy decision-making ball in the Fed’s court, but encourages them to own those decisions. On a one or two year basis, the Fed could report to Congress (and the public) whether or not it met its stated goals over that time. If it missed, by failing to hit a particular inflation target, for instance, it should lay out a complete case for why that happened. Did it depart from 2 percent inflation in order to better meet its employment target? Or was previous policy either too easy or too tight, in retrospect? This would help the public to better understand exactly what the Fed is trying to achieve.

While incorporating a number of monetary rule benchmarks into their analysis and instituting a self-review would be an excellent start to balancing Fed independence with appropriate Congressional oversight, the lynchpin compromise might lie in expanding the Fed’s research capacity. Specifically, increasing their research capacity by creating highly liquid markets for prediction of future nominal GDP, as well as real GDP, could be a crucial tool in helping the Fed better understand the actual state of the economy.

While such futures markets could eventually help move the Fed further away from discretionary policies, they would serve a vital public interest even if they were never tied directly to decision-making. In highly liquid futures markets, a large number of individuals make informed guesses about the future, and to do so with skin in the game. That kind of information, the “wisdom of the crowds,” should be extremely valuable to an institution that is intensively interested in determining exactly what stance of monetary policy would lead to appropriate growth in spending over the next year or two.

In sum, the steps required to bridge the gap between Fed independence and Congressional oversight are surprisingly noncontroversial. Sharing some additional analysis with Congress, conducting and communicating a rigorous and transparent self-review of past actions, and setting up a futures market to inform research are all low-cost, non-partisan, non-ideological opportunities. In other words, they are low-hanging fruit, ready to be picked by a policy community eager to pursue productive reform in 2017.