The False Promise of a Rules-Based Fed

That was the headline from Greg Ip in the WSJ today, he writes,

Last week the House of Representatives passed a bill that would bring about the most sweeping changes to the Federal Reserve since the 1930s. At the heart of the bill is a requirement that the Fed set interest rates according to a quantitative rule.

Like advocates of the gold standard, proponents of the bill blame many of the economy’s ills on the Fed exercising too much discretion because it succumbs to economic expediency or political pressure. Many see the Fed’s emergency lending during the crisis and its bond-buying since then as bailouts for big, reckless banks and a profligate federal government. They want rules to circumscribe such discretion.

But history shows that discretion is unavoidable no matter what sort of standard a central bank uses. “The practical difficulties of life cannot be met by very simple rules,” Walter Bagehot, an early editor of The Economist, wrote in “Lombard Street.” “Those dangers being complex and many, the rules for encountering them cannot well be single or simple. A uniform remedy for many diseases often ends by killing the patient.”

Legislating a rule doesn’t do away with discretion, but makes it more likely discretion will be exercised only after the rule has failed, perhaps at great economic cost.

Congress’ watchdog, the Government Accountability Office, would then decide if the Fed had changed its rule and investigate whether the Fed was “in compliance” with the law.

Numerous Fed officials and economists have noted, no rule can anticipate all the shocks and economic changes the Fed is likely to encounter, from a financial crisis to the “zero bound” on interest rates to a change in the neutral interest rate. So the bill in effect orders the Fed to do something it believes impossible; it would be like ordering the Fed to design a stock-picking formula then prove it will always beat the market.

Greg Ip’s conclusion is that one, either the Fed will change the rule or regularly deviate from it; or two, the Fed sticks to the rule until it becomes intolerable.

In the NY Fed’s blog, Liberty Street, Bianca De Paoli puts forward the case that policymakers should monitor financial conditions. This is not as to make financial stability the third mandate, but rather because this information helps reveal the state of the economy and the appropriate stance of monetary policy.

De Paoli writes,

Theory suggests that there’s a link between the natural interest rate and people’s attitude toward risk and the data appear to support this link. So a case can be made for adjusting monetary policy according to the level of risk taking in markets to the extent that this affects the natural rate. Failing to do so can lead to a non-neutral policy.

There could be an environment in which a given policy move changes the degree of risk taking in financial markets, affects market volatility, and influences financial conditions more broadly. Under such circumstances, the policy move should be calibrated to take into account that changes in uncertainty and risk taking critically influence the path of interest rates that is consistent with the central bank’s employment and inflation objectives.

If the Fed follows a rule that doesn’t take into account the level of risk taking in the market, could this result in a non-neutral policy?

I am not fully opposed to a quantitative rule, the rule might after all be a good counter-balance to absolute discretion.

However, with the fact that the Fed not only has to look at the American economy but also those outside of its own borders, tying the Fed’s hands at this very moment may not be a good idea. To quote Benoît Cœuré, “global interconnectedness seems to have altered the shock absorbing role of floating exchange rates”.

Will the rule take into account policy spill-overs too?


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