One of the most notable aspects of the response of western democracies to the cataclysmic economic events of the past decade has been the absence of any attempt to restrict the powers of the central banks. Far from it. With little political controversy, they have been allowed to increase their balance sheets by over 20 per cent of GDP, enormously widen their regulatory role, and profoundly alter the distribution of wealth in our societies.
Cynics will say that it is easy for politicians to approve of central banks when they choose voluntarily to pursue unprecedentedly easy monetary policy. It is when this is reversed that political problems would normally be expected to arise. But, in the US, we are now seeing signs that some members of Congress are seeking to shackle the Fed, not because policy has been too tight, but because they think it has been too accommodative.
Draft legislation has been published by two Republican members of the House, under which the Fed would be required to publish a formal rule that would specify the relationship between the Fed Funds rate and economic variables like GDP and inflation .
The central bank would be required to justify any differences between its rule and the well known Taylor Rule, and also to explain any deviations between its chosen rule and the actual policy it adopts.
The process would be subject to audit by the Government Accountability Office, followed if necessary by examination of the Fed Chair by Congressional committees. This is important for markets, because at present John Taylor says that his rule would set the Fed Funds rate at least 1.25 per cent higher than the FOMC has chosen.
Supporters of a rule based framework for monetary policy claim that this would have produced a better outcome for inflation and unemployment in the past than discretionary policy. An academic conference at the Hoover Institution in June, chaired by John Taylor, published some new research papers in support of his Rule, basically arguing that an auto pilot for the Fed would have worked better than human judgment.
Many other economists, including most at the Fed, accept that the Taylor Rule is an extremely useful input to policy, but few believe that it should be the only input. Although much smarter and less rigid than another auto pilot, the Gold Standard, it could lack flexibility when it is most needed.
A key problem with enshrining the Taylor Rule permanently into legislation is that the Fed has, in the past, interpreted the Rule very differently from John Taylor himself. In 2012, then Vice Chair Janet Yellen argued that Taylor’s original 1993 Rule was no longer her preferred interpretation of the Rule. She suggested a “balanced approach” alternative, in which the importance given to the unemployment/GDP objective was increased, relative to the importance given to inflation.
She also suggested an optimal control approach, under which interest rates would stay even lower than under the balanced approach, because policy needed to compensate for a prolonged period in which the stance had been too tight as a result of the zero lower bound on rates.
As the graph shows, these three different interpretations of the Rule were expected by Ms Yellen to differ by as much as 2 per cent in the appropriate level for the Fed Funds rate from 2012-15. Given these wide discrepancies, any of which could presumably be chosen by the Fed under the proposed legislation, it seems pointless to try to force a rule-based system on the FOMC just for the sake of it.
Furthermore, the Rule does not really help with several key problems faced by the FOMC today. The first is how and when to reduce the size of the Fed’s balance sheet, and how that decision should relate to the appropriate level of short rates. Next is how to determine the right relationship between economic objectives and financial stability when setting short rates. Based on their views on these two issues, the FOMC might decide that short rates should be either much higher, or much lower, than suggested by the Rule.
The Rule is also largely silent on another of the Fed’s main headaches right now, which is whether to treat the official unemployment rate as a good indicator of the amount of slack in the labour market. Many members of the FOMC, including the Chair, have argued that the amount of slack is greater than implied by the unemployment rate, because the labour participation rate has been temporarily depressed by the recession. The use of the Taylor Rule does not solve this debate, it simply treats it as if it does not exist.
Similarly, the Rule usually assumes that the neutral level of the real Fed Funds rate in the long run is 2 per cent, whereas some members of the FOMC now say that it has dropped below this level because of “headwinds” to growth. Again, the Rule simply glides past this debate, rather than solving it.
It is clear that the FOMC would be able to differ significantly from the Rule if it wanted to do so, just as it can under present arrangements. What, then, would be the point of the new legislation? First, it would probably place a much greater onus on the Fed to take the Rule seriously, and this would give the Rule much great prominence in the public debate than it has now. Secondly, FOMC members would need to report to Congress after every meeting, allowing for much greater political interference in monetary policy. This would be a high price to pay for any advantages the Rule might bring.
Will any of this actually happen? In the near term, the answer is probably not. Although it might pass in the House, there does not seem to be a majority in the Senate for this legislation, or support from the White House. But there has always been a great deal of latent support for rules based monetary policy in the Republican Party, and there is clearly a rising desire to shackle the Fed. This could get more interesting if the Republicans make gains in the Senate in November.