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Commentary By Peter Ireland, Mickey D. Levy

The Fed Needs a Rule for Raising Rates

Economics Regulatory Policy

Recent legislative initiatives, including the proposed Federal Reserve Oversight Reform and Modernization Act, ask the Fed to adopt, announce, and adhere to a monetary policy rule.  In a position paper drafted for this month’s meeting of the Shadow Open Market Committee, we argue that the Fed should not wait for Congress to demand that it take these important steps.  Instead, Federal Open Market Committee members ought to do so immediately, to reassure the public that they have formulated a coherent strategy for raising interest rates.

Renewed impetus for rule-based monetary policymaking comes, in large part, from recent news on the economy.  Solid growth in payrolls continues, keeping unemployment low and stable.  Consumer and business confidence have jumped sharply higher, making the outlook for spending more favorable than it’s been in years.  And, most important for the Fed, inflation has ticked upward as well.  Year-over-year growth in the price index for personal consumption expenditures, at 1.8 percent, now stands very close to the Fed’s long-run target.  Taken together, these data show that the Fed has all but achieved its dual mandate for employment and inflation and suggest that, if anything, growth is likely to accelerate in the months ahead.

Against this favorable backdrop, Federal Reserve policy has reached a long-awaited inflection point.  A recent speech by Chair Janet Yellen makes clear that the Fed is no longer struggling to provide sufficient monetary stimulus to fight deflationary stagnation.  Instead, that challenge has been replaced by a new one: the task of removing monetary accommodation at a pace that is fast enough to prevent a sustained overshoot of inflation above target but measured enough to avoid threatening the economic expansion.

Our paper outlines a strategy for meeting this new challenge most effectively.  The strategy requires the Fed to passively normalize the size of its balance sheet and to adopt and follow a monetary policy rule.  Although many possible rules exist, one of the most famous is John Taylor’s.  The Taylor rule dictates that the federal funds rate respond to movements in inflation and the output gap, with a coefficient of 1.5 on the former and 0.5 on the latter.  That behavior is consistent with the way most observers see monetary policy as being conducted already, with the Fed managing interest rates to control inflation and achieve modest countercyclical objectives.  But repeated reference to the rule would make monetary policy much easier for the public to predict and understand.  And by constraining the FOMC to respond only to persistent changes in macroeconomic fundamentals, the rule would reduce the chance that, through purely discretionary action, the Committee makes a serious policy blunder.

Consider, therefore, a Taylor rule with a 2 percent inflation target and a value of 1 percent value for “r-star,” the long-run real interest rate, suggested by Chair Yellen and other FOMC members who have emphasized that real rates have fallen noticeably in recent years.  With those settings, the rule implies a long-run value for the federal funds rate equal to 3 percent, consistent with the most recent set of FOMC projections.  But because inflation continues to run slightly below target and a small output gap still lingers from the last recession, that rule currently prescribes a setting for the funds rate of 2 percent: one percent below the long-run value, but also one percent above where the funds rate actually stands today.

By making consistent reference to this Taylor rule, FOMC members could emphasize that, in their view, monetary policy remains accommodative, but that further actions are needed simply to bring the funds rate back to where it should be, given current macroeconomic fundamentals.  Assuming that the economy continues to grow steadily, closing what remains of the output gap, the rule will dictate a pace for future rate increases driven almost entirely – and appropriately – by the speed at which inflation continues to move back to target.  The rule would therefore allow to the FOMC to remain “data dependent.”  So long economic conditions evolve as expected, however, the rule will constrain the FOMC members to follow through with rate hikes already planned and discussed.

Finally, the frequent complaint that a rule-based approach requires the Fed to act mechanically, ignoring valuable information not captured by inflation and output alone, is spurious and far off-the-mark.  No simple rule should be followed mechanically.  Instead, it should serve systematically to provide the starting point for deliberations as to whether and why the funds rate should be held below, above, or equal to the setting prescribed by the rule.  And deviations from the rule would be considered appropriate under extreme circumstances.

Adopting and following monetary policy rule, therefore, forms an integral part of any sensible strategy that the Fed might use for successfully raising interest rates, controlling inflation, and prolonging the economic expansion.


Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee

Mickey Levy is the chief economist of Berenberg Capital markets, LLC for the Americas and Asia and a member of the Shadow Open Market Committee. The views expressed in this column are the author’s own and do not reflect those of Berenberg Capital Markets, LLC.

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