Easy, Tight, or Neutral? Depends on the Monetary Policy Rule!
The Fed Oversight Reform and Modernization (FORM) Act, passed by the House of Representatives last November, requires the Federal Reserve to adopt a quantitative strategy for monetary policy. The Act does not impose a specific policy rule on the Fed. Instead, it asks the Fed to choose a rule of its own design and holds the Fed accountable for following that rule. The Act also recognizes that special circumstances may call for deviations from the adopted rule; at such times, the Fed need only explain why it chose policy actions differing from what its rule prescribed.
Since the FORM Act provides the Fed with freedom to choose whatever policy rule it deems most effective, it is useful to consider a number of well-known rules and ask what they imply about monetary policy today. Perhaps the most famous policy rule, developed by John Taylor, calls for the Fed to adjust the federal funds rate as inflation and output deviate from their long-run values. Gregory Mankiw has proposed a rule that is similar to Taylor’s, but focuses on unemployment, instead of output, together with inflation. Rules of this type are called “instrument rules” because their focus is on adjustments to the Fed’s target for the federal funds rate.
But other rules, directing more attention to the goals of monetary policy, have also been proposed. Scott Sumner, for example, recommends that the Fed direct its efforts towards stabilizing nominal GDP, while Lars Svensson advocates a policy of keeping the price level itself growing along a smooth path. Each of these rules identifies a numerical policy objective, but leaves it to the Fed to map out the specific actions – changing interest rates or the size of its balance sheet – needed to achieve that objective.
Jon Hartley’s MonetaryPolicyRules website usefully monitors what each of these rules implies. Beginning with the Taylor Rule, its original 1993 version shows that the funds rate currently lies below the value indicated by the rule. The implication is that the current stance of monetary policy is too accommodative and that the Fed needs to raise interest rates now to avoid excessive inflation later. Mankiw’s rule points to the same conclusion: In fact, because unemployment has fallen to 5 percent, it prescribes an interest rate even higher than that recommended by the Taylor Rule.
On the other hand, the 1999 version of the Taylor Rule, which places greater weight on stabilizing output, indicates that the funds rate is now quite close to the value implied by the rule, so that monetary policy can be judged to be in a neutral setting. Recent data suggest that nominal GDP comes close to a target path calling for four percent annual growth; by this standard, too, the current stance of monetary policy could be viewed as neutral. Continued slow inflation compared to the two percent target embedded into Svensson’s rule, moreover, suggests that monetary policy has been, and continues to be, inappropriately restrictive.
Even this small set of comparisons shows that different policy rules can offer very different perspectives on whether monetary policy is easy, neutral, or tight. These rules – and the experts who designed them – may reasonably disagree on what the Fed should be doing at any given point in time, and no act of Congress can legislate this scientific uncertainty out of existence. At the same time, the comparison also makes clear that the FORM Act shouldn’t be viewed as an attempt by Congress to “hijack” monetary policy, pushing it in one direction or another, towards excessive ease or tightness.
Instead, the benefits of a ruled-based approach to policymaking will accrue over time. By announcing and following a rule, the Fed can more effectively communicate its goals and strategy to Congress and the public. Populist criticisms, accusing the Fed of operating mysteriously for the benefit of an elite few, will lose much of their appeal once the Fed demonstrates that its policies are chosen consistently in order to achieve goals for a small number of observable variables: inflation, unemployment, or GDP. Likewise, the consistent behavior demanded by a rule – which naturally requires the Fed to make similar decisions under similar conditions – will help the Fed minimize uncertainty surrounding its own actions, which can distort business and financial decision-making.
Finally, announcing and following a policy rule as required by the FORM Act would help Fed officials break away from the vagaries of the daily news cycle and keep their focus on underlying fundamental trends. Too much attention, for example, is being paid to volatility in Chinese stock prices and what it might imply for Fed policy in 2016. A policy rule would make quite clear that such developments properly affect Federal Reserve policy only to the extent that they have broader implications for US output and inflation.