Fed Rules Beat Discretion, Then and Now

The Fed Oversight Reform and Modernization (FORM) Act would require the Federal Reserve to adopt an identifiable rule describing how it manages key policy interest rates.  The proposed legislation, sponsored by Representative Bill Huizenga (R-MI), does nothing to change the Fed’s dual mandate for its policy objectives: maximum employment and stable prices.  In testimony before Congress and in a recent letter to Congressional leaders, Fed Chair Janet Yellen argues that such a rule would threaten the central bank’s independence and “severely impair” its ability to fulfill the dual mandate.

In essence, the debate between Congress and the Fed revisits long-standing arguments about the relative merits of “rules versus discretion” in the implementation of monetary policy. Academic research on this topic points strongly to the advantages that accrue when monetary policymakers follow a rule.  In a 1951 paper, “The Effects of a Full-Employment Policy on Economic Stability: A Formal Analysis,” Milton Friedman questioned whether the Fed possesses the detailed economic information needed to conduct successful discretionary stabilization policy.  In their 1977 article, “Rules Rather Than Discretion: The Inconsistency of Optimal Plans,” Finn Kydland and Edward Prescott described how the Fed could achieve the best of both worlds – lower inflation without any loss in employment – by eschewing discretionary actions and following a pre-announced rule instead.  And in a 1993 paper, “Discretion Versus Policy Rules in Practice,” John Taylor introduced his famous rule for adjusting monetary policy rates and argued that the Fed was most successful in achieving its goals when its policy actions followed closely the prescriptions of the Taylor Rule.

Although the Fed never has adopted an explicit policy rule, and resists doing so today, it is instructive to revisit a discussion of the rules versus discretion debate that occurred at the December 1984 meeting of the Federal Open Market Committee under the chairmanship of Paul Volcker.  A detailed transcript of this meeting is available to readers interested in its details. Towards the end of the discussion, Chairman Volcker offered these comments:

Chairman Volcker:  Nobody has talked much about the fact that we are working with economic projections and I find … that the Committee puts tremendous weight on them. The economic projections are consistently unreliable in terms of ex post judgment that’s made about what the satisfactory quarter-to-quarter movement is in the economy.  And I think that’s just a fact of life; it’s not that the projections are any worse than anybody else’s ….  That’s another way of saying you can’t fine-tune on the basis of economic projections. (p.21)

The Chairman’s point echoes those from Friedman’s famous essay.  The Fed employs many talented economists, and provides them with the most detailed and up-to-date information about economic conditions.  The inherent difficulties in forecasting, however, mean that its projections often will be in error.  These same points could be used, today, to question the wisdom and effectiveness of the FOMC’s current, “data-dependent” policy decisions and push Committee members towards announcing a rule that would limit the temptation to attempt too much fine tuning.

Nonetheless, earlier in the discussion at the same 1984 meeting of the FOMC, Philadelphia Bank President Edward Boehne identifies ways in which the Committee’s members might usefully incorporate their own judgments about the state of the economy and the stance of monetary policy into a rules-based framework:

Mr. Boehne:  On this judgment versus rules debate, there are different kinds of views as to how you can apply judgment.  You can have a judgmental approach which says that when things don’t go according to plan you … make a judgmental response to whatever the deviation is …. Or you can have a judgmental approach which says that if we were on an automatic response of some kind … are there any good reasons why we might not want to go in that direction? (p.10)

These comments recognize that the FOMC never would want to tie itself completely to a mechanical rule.  Instead, Committee members would take the prescriptions of the rule as a starting point before asking whether or not a wider range of information would justify a deliberate deviation from that rule.  These views of how a policy rule might be implemented “in practice” appear fully consistent with those articulated by John Taylor and resonate, as well, with the FORM Act itself, which, as described by its Congressional supporters, does not require the Fed to follow a rule mechanically, but only to “regularly communicate how its policy choices compare to a benchmark rule.”

Thus, it is extremely difficult to see how the FOMC would be “severely impaired” by a legislative requirement to conduct monetary policy with reference to a pre-announced rule.  Indeed, as the FOMC itself appeared to recognize as far back as 1984, a rules-based approach to policymaking offers many advantages and surprisingly few costs.