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Commentary By Diana Furchtgott-Roth

PLACEHOLDER TITLE Diana Fed op-ed

Economics Finance

Federal Reserve Chair Janet Yellen delivered her Semiannual Monetary Policy Report to Congress on Wednesday and Thursday to the House Financial Services Committee and the Senate Banking Committee. She reiterated the Fed’s policy for “gradual increases in the federal funds rate over time” and “to gradually reduce the Federal Reserve's securities holdings by decreasing its reinvestment of the principal payments it receives from the securities held in the System Open Market Account.”

“Gradual” is an imprecise term, and can be applied to a wide range of Fed actions.  I would suggest that the Fed choose a meaning of “gradual” that is faster than the one laid out in Chair Yellen’s testimony.

Chair Yellen described the labor market as strengthening, and the economy growing at a moderate pace.  This seems like an appropriate time to move monetary policy back to historical norms.

But then Chair Yellen suggested that the Fed might never move back to historical norms. She stated that “the federal funds rate remains somewhat below its neutral level--that is, the level of the federal funds rate that is neither expansionary nor contractionary and keeps the economy operating on an even keel. “  She added that “the neutral rate is currently quite low by historical standards” and “the longer-run neutral level of the federal funds rate is likely to remain below levels that prevailed in previous decades.”

If the economy is getting stronger, now is the time to be moving back to historical norms.  The federal funds rate of 1.25 percent is far below average rates of 5 percent, harming savers and lowering returns for the banking sector—which then reduces lending.  Now is the time to increase rates and reduce the Fed’s $4 trillion balance sheet, balances that were that were accumulated during cycles of quantitative easing after the 2007 to 2008 recession.

The Fed should develop a plan to raise rates and reduce its balance sheet in order to get rid of distortions and increase certainty in financial markets.  This could begin with halting reinvestment of the funds of its maturing assets, which would immediately begin to shrink its portfolio.  Instead, the Fed plans to halt some reinvestment of the funds.

The Shadow Open Market Committee, a non-partisan group that provides advice to the Federal Open Market Committee, has proposed that the Fed adopt a flexible rule and stick to it.  The Fed has the choice of adopting a rule-based approach to set the Federal funds rate, or a discretionary approach, where members raise or lower the rate depending on their instincts about the economy. 

At the moment the Fed is using a discretionary approach.  Even when the Fed announces targets—such as Chairman Bernanke’s target that he would start raising rates when the unemployment rate reached 6.5 percent--it rarely keeps to them.

By formulating and stating a rule, the Fed would enhance its credibility.  It could explain why it is adjusting the rule and what we have learned about models that do not work.

Federal Reserve Vice Chair Stanley Fisher has argued for discretion in the Fed.  He has been quoted as saying that he would rather have MIT Professor Robert Solow’s judgement than a model—but that he would rather have Robert Solow with a model than Robert Solow without one.

Although the search for better policy rules is never done, it does not follow that discretion is preferable to a rule. We should acknowledge the imperfect knowledge that we have but this does not mean that we should not have a rule.

One possible rule is the Taylor Rule, where the federal funds rate is set to some measure of desired growth and inflation. The Taylor rule, named for Stanford University economics professor John Taylor, a possible candidate for the next Fed chair, describes behavior that Chair Yellen in 2012 said that the Fed was doing already. But by announcing it, the Fed would enhance the nature of its behavior.  By adopting a Taylor-type rule, the Fed would also be seen as looking back in time, to the 1990s, and importing the success to the present. 

The time to move back to historical norms is now. Announcing a rule could be part of an integrated policy of raising the Federal funds rate and reducing the Fed’s balance sheet.  It is costless, and the Fed could seize on it now to improve monetary policy in the economy.