Jay Powell’s Fed and the Right Monetary Policy Rule

As a new Fed chair, it remains to be seen where Jay Powell will ultimately take U.S. monetary policy. One area, however, where he is already breaking with his predecessors is his open endorsement of monetary policy rules. This largely overlooked development is remarkable given the Fed’s past aversion to such rules.

In his first testimony to Congress, Chair Powell said that the FOMC “routinely consults monetary policy rules” and that he “find(s) these rule prescriptions helpful.” He reiterated this point in his testimony last week. His warm embrace of their use was complemented by the separate publication of benchmark rules in the Fed’s monetary policy reports submitted to Congress and on the Board of Governor’s website.

The Jay Powell Fed’s new enthusiasm for monetary policy rules is a step in the right direction. These rules constrain the Fed so that it responds in a systematic manner to changes in the economy, in turn making its’s behavior more time-consistent, predictable, and accountable.

How far the Fed’s journey toward monetary policy rules will go is unclear, but the fact that it is happening is progress.

A key challenge the Fed will face is determining which monetary policy rules are the most helpful. A poorly designed rule can be just as destabilizing as no rule. The Fed, for example, closely followed the “real bills” doctrine during the late 1920s and early 1930s, magnifying the ebbs and flows of the economy and helping spawn the Great Depression. This disaster, in turn, brought about a long-lasting distaste for monetary policy rules.

This concern is one reason the Fed currently looks at multiple monetary policy rules to inform its decisions. A consensus approach dilutes the danger of one potentially destabilizing rule. Over time, though, the Fed will need to hone in on the most effective rules.

To that end, rules targeting the growth of total dollar spending warrant special attention. These maintain neutral monetary conditions, avoid inflation confusion, and promote financial stability across the economy.

Maintaining neutral monetary conditions requires that money’s “velocity” — the speed with which it circulates — be offset by proportional changes in the money supply. For example, if Americans go on a spending spree and money starts circulating more rapidly, the stock of money should decline by a similar amount, and vice versa. Such countervailing forces are beneficial since money is the one asset used in every transaction; disrupt it and you disrupt every market.

A monetary policy rule that stabilizes the growth of total dollar spending avoids such disruptions because it automatically causes offsetting changes in the velocity and supply of money.

Milton Friedman made a similar argument when, writing in The Wall Street Journal in 2003, he argued the “Fed must see to it that quantity of money changes in such a way as to offset movements in velocity” before noting how it had been happening since the mid-1980s. Some research connects the relative stability during that time period with the Fed’s effective targeting of total dollar spending.

The rule also removes much of the guesswork when it comes to inflation. Currently, the Fed seeks only to respond to sustained changes in inflation while avoiding temporary ones. It is impossible to know the difference in real time, yet getting it wrong can be costly. In 2008 the FOMC kept its interest rate target fixed for almost six months, and even considered raising it, because inflation was rising. The inflation uptick proved temporary, while the delay in cutting the interest rate target helped compound the Great Recession. Focusing instead on total dollar spending would have avoided the confusion. 

To be clear, inflation would become more countercyclical — falling during booms and rising during recessions — with such a rule. That, however, would improve financial stability by ensuring better risk sharing between creditors — who would collect more in real debt payments during booms and less during recessions — and their debtors. In other words, it allows a debt-laden world to operate more like an equity-based world, and makes economies with lots of private debt (think pre-2007 America) less susceptible to shocks.

For these reasons, the Fed should move toward rules that target total dollar spending. The most recognized version targets nominal GDP. It has a long history, but has gained popularity since the crisis and has even been endorsed by some FOMC members. 

Jay Powell is well positioned to make it one of his lasting legacies. His early endorsement of monetary policy rules is a start. Let’s hope he continues down the path.