December 18, 2014

Why the Fed Should Follow Rules

Alexander Salter

Summary

How should monetary policy be conducted? What previously was a question of interest only for a subset of economists has exploded into popular debate since the 2008 financial crisis. This, no doubt, is due to the Federal Reserve's unprecedented activities during the crisis.

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How should monetary policy be conducted? What previously was a question of interest only for a subset of economists has exploded into popular debate since the 2008 financial crisis. This, no doubt, is due to the Federal Reserve's unprecedented activities during the crisis. Some, such as Stanford's John Taylor, have accused the Fed of fueling a speculative boom by keeping interest rates "too low for too long" in the years running up to the crisis. Others, such as monetary-economics blogger Scott Sumner, argue instead the Fed was responsible for not acting swiftly and decisively enough when the trouble in asset markets became apparent. Whatever the reason, many believe that the Fed bears some of the responsibility for putting the "Great" in Great Recession, and that its activities must be scrutinized to discover how its operating framework can be changed to avoid such a calamity in the future.

Monetary policy can be defined as changing the supply of money in order to achieve some predetermined macroeconomic goal. In this case, the organization doing the changing is the Fed, and the macroeconomic goal is nominal stability -- preventing large and unexpected changes in aggregate demand. Typically this can be thought of as trying to offset changes in the demand to hold money with changes in its supply.

Money is the one good in the economy that does not have a market of its own in which it is independently priced. As such, if the demand to hold money changes, the only way markets can fully adjust is if relative prices across the entire economy change. Since prices, and especially wages, are costly to change, the adjustment at first is highly imperfect, which may result in a misallocation of resources. Ideally, the Fed prevents the need for such costly price adjustments by increasing the money supply if demand to hold it rises, and vice versa. This keeps the money market as close to equilibrium as possible.

A significant debate within monetary economics is whether the monetary authority should act according to a predetermined rule, or whether it should be allowed discretion to act as the circumstances require. The financial crisis seems to suggest the latter. After all, how can crises be avoided if the rule the Fed is bound to follow prevents it from taking decisive action when necessary?

However, this line of thought gets it backwards. A stable and predictable rule is necessary to anchor market actors' expectations by reducing uncertainty over the future stance of policy. This enables market actors to better coordinate their trading activity, increasing welfare by enlarging the gains from exchange. So long as market actors perceive the rules-based regime to be credible, the expectation of stability afforded by the rule will prevent market actors from engaging in the panicked behavior that can precipitate crises in the first place.

Rules are preferable to discretion for three chief reasons. The first is the famous (at least within economics) time inconsistency problem. This basically says that without something tying the Fed's hands, the public will rationally expect the Fed to engage in more money printing than is optimal, resulting in too much inflation. The Fed can credibly commit to lower inflation, and hence increase public welfare, by binding itself to a rule on which it cannot go back. The second lies in the fact that the Fed often lacks the knowledge to fine-tune a system as complex as the U.S. economy. Given this complexity, providing a stable framework is the best the Fed can do. Lastly, we must also remember the Fed is a bureaucracy that is not accountable to market actors. It is subject to status quo bias, as Harvard's Greg Mankiw argues, like all bureaucracies. Therefore, what is best for the Fed may not be what is best for the economy.

Realizing that a rule is preferable to discretion is only the first step toward reforming monetary policy. We must still decide which rule, from the multitude that economists have proposed over the years, ought to be adopted. Perhaps a strict inflation target, similar to that in the charter of the European Central Bank, is preferable. Perhaps Scott Sumner's proposed regime of using nominal gross domestic product (NGDP) targeting has the best chance of offering stability. More sweeping still, perhaps the Fed should be jettisoned in favor of a return to a gold standard, or some other commodity standard. While this last option may seem fantastic, recent research suggests the Fed has not outperformed the classical gold standard in delivering monetary stability, and may in fact have made things worse.

Reasonable people can disagree over what rule a central bank should adopt, or whether we ought to have a central bank at all. It is clear, however, that the current discretionary regime is not in the public interest. Whichever way forward is chosen, we must remember that any reform, if it is to be effective, must not limit itself to monetary theory narrowly conceived, but must incorporate political economy considerations as well.