Rules Would Make Monetary Policy More Transparent, Independent

President Trump has expressed displeasure with recent Federal Reserve decisions to raise their target interest rate. Trump has suggested that he is a “low-interest rate person.” Much of the press commentary looks at this from a political angle, but the criticism also raises some deeper issues surrounding monetary policy, particularly the importance of clearly defined monetary rules.

When considering the President’s criticism of Chairman Powell, it’s important to distinguish between tactical disputes and strategic disputes. Thus, one could imagine someone preferring that the Fed set a different inflation target, say four percent inflation instead of the current two percent target. That would represent a difference in preferred strategy. Alternatively, a Fed critic might accept the desirability of the two percent inflation target, but question whether the current policy stance was appropriate, i.e. likely to achieve two percent inflation. To my knowledge, the President has not made clear whether he is making a tactical or strategic criticism. In fairness, one often sees Fed critics gloss over this distinction.

One problem with evaluating Fed actions is that the actual policy goal is more complicated than a simple two percent inflation target. The Fed has a dual mandate for high employment and stable prices. Fed officials interpret this mandate as calling for two percent inflation (using the PCE index) as well as an unemployment rate that is roughly 4.0 percent to 4.6 percent. This “natural rate of unemployment”, i.e. the rate that can be sustained without triggering high inflation, is itself difficult to estimate. In recent years, the Fed has gradually reduced its estimate of the natural rate, as the labor market shows indications of being able to achieve lower than previously expected unemployment, without triggering inflation.

The bottom line is that the Fed’s actual policy goals involve enough “wiggle room” so that reasonable people may disagree as to which sort of tactics are optimal. And this is why it’s hard to be certain as to whether President Trump objects to the Fed’s announced policy goals, or simply believes that those goals can be achieved with a lower path for interest rates—a tactical dispute.

Ever since the high inflation of 1966-81, many experts have suggested that an independent central bank can control inflation more effectively that one under the direct control of politicians. The basic argument is that the sort of expansionary monetary policy that is likely to lead to high inflation is often politically popular in the short run. Hence an independent central bank is more likely to resist the siren call for low interest rates to spur spending in the economy.

If Fed independence is desirable, then it is important to consider policy targets that are less ambiguous, less likely to be criticized by public officials. For instance, the ECB has a single mandate to control inflation and thus may have an easier time brushing aside political calls for easier money to boost the economy. Unfortunately, a simple inflation target is subject to the “never reason from a price change” problem. Rising inflation might represent excessive spending, as in the 1960s, or it might represent an adverse supply shock, as during 2007-08. If the Fed responds to supply-side inflation in the same way as demand-side inflation, they may end up destabilizing the economy.

A better approach is to find a single policy goal that best incorporates the Congressional goals embedded in the dual mandate. An increasing number of prominent economists have suggested that targeting nominal GDP growth at a steady rate of four or five percent/year is the best way to achieve the dual mandate, as NGDP growth includes both inflation and real GDP growth. With a single NGDP growth target, the Fed would have an easier time brushing aside political criticism.

If NGDP were growing at close to the announced policy target, then this would suggest that interest rates were currently set at an appropriate level. If politicians still called for easier money, the Fed could respond, “We are currently achieving our policy goals. If Congress disagrees with these goals, they can always give us a new mandate.” Admittedly, there is nothing stopping the Fed from making that argument even today. However, with the current complex inflation/unemployment policy goals, it’s much harder for outsiders to evaluate whether Fed policy has indeed achieved its policy goals.

NGDP targeting would not completely depoliticize monetary policy, however, it would make policy more transparent and easier to monitor, and hence make it a bit easier for the Fed to preserve its independence. This is a feature of NGDP targeting that is often overlooked when comparing the proposal to today’s more complicated policy regime.

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