March, 2016

Nudging the Fed Toward a Rules-Based Policy Regime

  • Scott Sumner

    Ralph G. Hawtrey Chair Emeritus of Monetary Policy
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There is a great deal of academic research suggesting that monetary policy should use a rules-based approach (e.g., Kydland and Prescott 1977, McCallum 1985, Plosser 2014). However, Fed officials have generally been opposed to any sort of rigid policy rule. 

There are two types of policy rules, both of which the Fed finds problematic. One involves a commitment to target a macroeconomic variable such as inflation, or nominal GDP, at a specified rate of growth. Today many central banks aim for approximately 2 percent inflation, although such rules are generally regarded as being flexible—with some weight also being given to output and/or employment stability. Even the European Central Bank, which has a simple inflation mandate, must also ensure that the eurozone monetary regime remains stable and viable. 

The Fed has a dual mandate for stable prices and high employment, which it interprets as 2 percent inflation and unemployment close to the natural rate. However, there is no clear indication of the weights assigned to each variable, and hence current policy cannot be viewed as a fully rules-based monetary regime. If both inflation and unemployment are above target, the Fed has discretion as to which problem deserves more attention. 

In other cases, the term “policy rule” refers to an instrument rule, such as the famous Taylor rule, which would require that the Fed target the nominal fed funds rate (see Taylor 1993). Key Fed officials also oppose instrument rules, which they suggest do not provide adequate flexibility. They worry that if the natural rate of interest and/or the natural rate of unemployment change, then the Taylor rule could lead to a suboptimal policy. In principle, the rule can adapt to changes in these parameters, but it may be very difficult to estimate the natural rate of either unemployment or the real interest rate. 

Elsewhere, I have argued that the Fed’s discretionary approach did very poorly during the Great Recession and that the Fed should adopt level targeting of nominal GDP (Sumner 2012). I have also suggested that policymakers should target the market forecast of future nominal GDP, or at least the Fed’s internal forecast, if a mar- ket forecast is not available (Sumner 2015).  In this article, I will sim- ply assume that a nominal GDP-level target is the best option; however, all of the arguments presented here could equally be applied to a different policy target, such as one for 2 percent inflation. 

Given the Fed’s opposition to a rigid policy rule, it’s worth asking whether the Fed can be “nudged” in the direction of a policy rule, through some more modest and less controversial policy reforms. Here I’ll suggest three such reforms: first, asking the Fed to more clearly define the stance of monetary policy; second, asking the Fed to more clearly evaluate past policy decisions; and third, asking the Fed to define the outer limits of acceptable deviation in aggregate demand from the target path. I will also argue that if the Fed starts down this road, it will likely lead to the eventual adoption of nominal GDP-level targeting. 

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