The Only Fed Rule Is That There Are No Fed Rules

Monetary policy is too much of a political balancing act to burden it with a strict template.

One of the most frequent recommendations for monetary policy is that the Federal Reserve should be subject to a rule. Milton Friedman proposed money-supply-growth rules in the 1970s, and since then we have seen calls for interest-rate rules, nominal GDP rules, inflation rules, price-level rules and Taylor rules, among other options. Often I’m sympathetic, but the very nature of American government makes such rules impossible to implement.

Let’s step back for a moment and consider Congress, the most fundamental institution of American democracy. Congress has the ultimate power of the purse, subject to presidential and Supreme Court vetoes. One year’s Congress may try to bind the hands of the next, but those attempts usually fail. Various budgetary rules for fiscal restraint have been tried and discarded. That’s unfortunate in my view, but it’s hard to force major changes on a system that doesn’t really want them.

Now enter the Fed, which I think of as a tool of Congress and the president. It gives Congress a means of promoting economic growth and stability (one hopes), as well as a path for deflecting the blame if tough decisions must be made. Congress insists that the Fed is “independent,” precisely for this reason. But if voters hated what the Fed was doing, Congress could rather rapidly hold hearings and exert a good deal of influence. Over time there is a delicate balancing act, where the Fed is reluctant to show it is kowtowing to Congress, so it very subtlety monitors its popularity so it doesn’t have to explicitly do so.

If we imposed a monetary rule on the Fed, even a theoretically optimal rule, it would stop the Fed from playing this political game. Many monetary rules call for higher rates of price inflation if the economy starts to enter a downturn. That’s often the right economic prescription, but voters hate high inflation. The Fed would probably lose its political capital if it had to follow through on the rule, and monetary policy would end up politicized for a long time.

Central bank quasi-independence is a quite a fragile institution, and it is maintained only by allowing central banks to juggle lots of balls at once. If you make a rule too tough, even a good rule, sometimes what you get is a rule that snaps and breaks. Congress and the president don’t always want the results of the rule, and the Fed might prefer to keep its ability to perform its juggling act.

Up through the New Deal, the U.S. did have a monetary rule: the gold standard. President Franklin Roosevelt broke the dollar’s tie to gold in 1933, thereby busting the rule, and output surged. Since then, rules have been taken much less seriously.

Rules supposedly bring predictability. But central banking is a multidimensional problem where predictability along the lines of one variable can mean less predictability for other, no less important variables. When the Swiss experimented with a version of money supply targeting in the early 1980s, they found it made their exchange rate too volatile.

These days, a rule is most politically stable when the system in question doesn’t have enough flexibility to manage discretion. The European Central Bank adhered to pretty strict inflation rules during the euro crisis of 2011, in part to keep inflation-averse German voters from rebelling. The result was strong deflationary pressures on the euro-zone periphery and an economic disaster. Yes, the ECB chose the wrong rules, but the best rules are often politically impossible, just as perfect central bank discretion is also impossible.

Nonetheless, I am usually heartened when I hear economists call for central bank rules. The rule will probably never happen, but the rhetoric pushes central bank discretion in a better direction.

My favorite candidate for a monetary policy rule is nominal GDP targeting, whereby the central bank tries to keep the flow of nominal purchasing power on a stable growth path. Under this rule, if GDP growth falls, the Fed should boost price inflation to maintain aggregate demand. The bad news is that hitting voters with more inflation during a crisis period probably wouldn’t be very popular, and might be overturned. Nonetheless, in 2008 too many Fed officials were worried about price inflation, even when deflationary pressures were on the horizon. The advocates of nominal GDP targeting helped direct the attention of the Fed toward the problem it ought to be solving, in this case shortfalls in demand.

The next time you hear talk of implementing monetary policy rules, don’t believe it will happen. But you should nod and smile anyhow.