The guest commentary below was written by Dr. Daniel Thornton of D.L. Thornton Economics.
There has been a long-standing debate in the economics profession as to whether monetary policy should be conducted using a policy rule or by discretion. The debate has intensified to the point where a number of prominent economists, including several Nobel Prize winners, have formally supported legislation that would require the Federal Open Market Committee (FOMC) to conduct monetary policy using a policy rule.
This essay explains why monetary policy has always been and always will be conducted with discretion. Consequently, it’s time to change the monetary policy debate. Specifically, the debate should focus on the limits of monetary policy and a framework should be developed that will force the FOMC to conduct monetary policy within these limits.
The Fed will never use a policy rule
To understand why, it is important to know what a policy rule is. Basically, a policy rule is a formula that the FOMC would use to set the target for its policy instrument, the federal funds rate. The federal funds rate is the interest rate one bank pays another when a bank borrows another bank’s deposit balances at the Federal Reserve. The term of the loan is one day. Funds borrowed one day are repaid the next. The FOMC implements policy by setting a target for the federal funds rate. Since the mid-1990s the funds rate has stayed close to the FOMC’s target.
The policy rule tells the FOMC where to set its target for the funds rate. It also tells policymakers when and by how much to adjust the target up or down when the variables in the rule change. The most well-known policy rule is called the Taylor rule; named after John B. Taylor who suggested it. The equation for Taylor’s rule is presented at the end of this essay, but it is simple enough to describe in words. According to the rule, the federal funds rate target would be determined by just three variables:
- The gap between the actual rate of inflation and the FOMC’s inflation target (currently 2%)
- The gap between the actual level of output and potential output (the so-called output gap), and
- The equilibrium real rate of interest (aka, the natural rate of interest).
The rule says that policymakers would set the nominal funds rate target equal to the natural rate plus the inflation target if inflation is equal to the FOMC’s target and output is at its potential. The rule would also tell the FOMC how much to raise its target for the funds rate when inflation is higher than the inflation target or how much to reduce it if inflation is below the inflation target. Likewise, the rule would tell the FOMC how much to increase its funds rate target if output is above potential or how much to reduce it if output is below potential.
The FOMC would not have to adopt the Taylor rule
The rule could be as simple or complicated as they choose. But the FOMC would have to decide on a particular rule. However, the Taylor rule is sufficient to show why the FOMC will never use a policy rule. “Why not?” There are a number of reasons, but for starters, the FOMC would have to agree on how much to adjust its target for the funds rate when inflation deviates from the FOMC’s inflation target or when output deviates from potential output.
It would be very difficult to get the FOMC to agree on these magnitudes. There are several reasons, but here is one example: Economists have two theories of inflation—the money theory and the so-called Phillips curve or output gap theory. Let’s assume that the FOMC believes that inflation is solely due to the gap between actual output and potential output—the Phillips curve theory; inflation increases when output is above potential and decreases when output is below potential. If this were the case, there would be no need to include the difference between inflation and the FOMC’s inflation target in the policy rule. Inflation and output could be stabilized simultaneously by simply adjusting the funds target to keep actual output close to potential output. The policy rule would be very simple.
However, as I have noted here and elsewhere, neither theory of inflation works well in practice. The Phillips curve is essentially useless for determining the rate of inflation. The Phillips curve has changed regularly over time. Consequently, no policy rule that I’m familiar with suggests that the funds rate should be determined solely by the output gap. However, the money theory of inflation fares no better. Hence, it will be difficult, if not impossible, to get the members of the FOMC to agree on exactly how much to adjust the funds rate target when inflation deviates from its inflation target or actual output deviates from the FOMC’s estimate of potential output.
There is also considerable uncertainty about the natural rate of interest, whether it is constant as the Taylor rule requires or whether it changes over time and, if so, why and how much. As I have noted here, potential output is a concept that does not have measurable counterpart in the real world. It’s defined and measured differently. However, that makes little difference because all estimates look very similar to a historical trend in output. Hence, economists have experimented with a wide variety of “gap” measures (for example, see Atlanta Fed). Then there is the problem that policymakers seem to care about a variety of things that are not easily included in a specific policy rule—“financial stability,” “conditions in the labor market,” “credit market conditions,” and so on. The more policymakers care about such things, the less likely they will adopt a policy rule.
Real-World Economies Are Extremely Complicated
However, oddly enough, the biggest reason that policymakers will never adopt a policy rule is the same reason that many modern economists favor policy rules. Many economists favor using policy rules because they work well in models. They work well in models because in models the economy’s structure is determined and unchanging or changing in limited and highly predictable ways.
Of course, this is not true of real-world economies. Real world economies are extremely complicated, not completely understood, and constantly changing. Moreover, real economies change in ways that are almost always impossible to predict and often difficult to understand in hindsight. For example, we still don’t understand what caused the Great Depression. Hence, monetary policy has always been and will always be discretionary. The FOMC will never adopt a policy rule. If it did, it wouldn’t be long before it changed it.
To me, this is so obvious that I don’t understand why economists invest so many resources debating whether rules are better than discretion for conducting monetary policy and trying to get legislation requiring the FOMC to adopt a policy rule. These resources should be devoted to debating what monetary policy can reasonably do.
Debating The Limits of Monetary Policy
The profession should debate the limits of monetary policy not whether or not the FOMC should adopt a policy rule. I am trying to move the discussion in this direction. In Fixing a Bad System, I have argued that the FOMC should be required to conduct its interest rate policy using what I call economic reality-based monetary policy (ERMP). That is, the FOMC should be required to conduct monetary policy within limits imposed by various economic realities.
The two realities I propose are:
- Credit is most efficiently and effectively allocated by the market and, hence, by economic fundamentals, and
- Interest rates determine the allocation of credit and, hence, actions that the FOMC takes to affect interest rates necessarily distort the allocation of credit and economic resources.
The FOMC could still implement monetary policy by targeting the federal funds rate, but these realities would have prevented the FOMC from keeping it funds rate target at zero for over six years after the recession ended and would have limited the FOMC’s QE and forward guidance policies. ERMP would preserve and enhance the Fed’s independence. It would make the Fed more accountable and monetary policy more predictable. It would also eliminate the need for direct congressional oversight.
A Brief Primer on The Taylor Rule
This is a Hedgeye Guest Contributor piece written by Dr. Daniel Thornton. During his 33-year career at the St. Louis Fed, Thornton served as vice president and economic advisor. He currently runs D.L. Thornton Economics, an economic research consultancy. This piece does not necessarily reflect the opinion of Hedgeye.