Should the Fed’s discretion be constrained by rules?

Fed Chair Janet Yellen

The Federal Reserve is the most second-guessed agency in the government. Congress regularly calls on the Fed Chairperson to explain its actions and part of Wall Street is always blaming the Fed for something it did or did not do. But suffering such scrutiny comes with being responsible for important policy making. A deeper issue, which has persisted for decades, is whether the Fed’s discretion in policy making should be constrained by rules. Even without specifying rules in legislation, which would be hard to imagine, the idea that rules have advantages may have affected policy decisions. And not for the better.

The Fed is mandated to provide high employment with low inflation. And both the actual conduct of the Fed and the general rules that have been proposed, such as the Taylor rule, named after Stanford economist John Taylor, have been informed by this mandate. However, there is always leeway in emphasizing one goal or the other, and most rules advocates argue they would protect against policymakers who, for political reasons, risked too much inflation by being too expansionary.

In fact, history provides little or no cause to question the Fed’s independence from politics or its commitment to both parts of its mandate. The U.S. has had one stretch of high inflation since the Fed gained its independence in 1951, and the origins of that stretch had nothing to do with recklessness at the Fed. And it ended after Fed tightening helped unseat two presidents.

The stretch began near the end of the Vietnam war, when President Nixon removed the price controls that he had applied a year earlier. That removal added to inflation in 1973 and, with hindsight, one could fault the Fed, then led by Nixon’s former economic advisor, for not responding aggressively to this arguably temporary shock. The big surge in inflation then came with the first great oil price shock when the OPEC cartel was formed in late 1973. That quadrupled the world oil price and began a rising price-wage spiral through the tightly indexed wage contracts of that time. After that, a restrictive Fed policy helped bring on the 1974-75 recession that contributed to President Gerald Ford’s defeat.

Inflation was fueled again when the Shah of Iran was overthrown in 1979, sending oil prices still higher. The Volcker Fed responded with a severely restrictive policy that sent short-term rates soaring to 20 percent. This draconian tightening brought on the very deep and long recession of 1980-1982 that helped defeat President Jimmy Carter, and then ended the inflationary surge.

But if the fear of a reckless or politicized Fed has little or no basis in history, what about the idea that rules may simply do better because markets and businesses like the future certainty that rules provide? In the real world, the opposite is almost surely true. Rules rely on past observations, but the economy and its institutions continually evolve. Rules do not keep up while policymakers with discretion can hope to.

Even more important than evolutionary changes, the big challenges to monetary policy come from shocks and surprises that rules cannot anticipate or prepare for. These are the events that make expert discretionary policymaking invaluable. The inflationary shocks of the 1970s and the financial crisis of the Great Recession are the two biggest events in this category. But lesser shocks that are beyond the reach of rules are not infrequent.

During the relatively smooth economic period between the mid-1980s and the mid-2000s, many observers saw the economy as inherently stable and the Fed’s role as effectively passive. The debate over rules vs. discretion subsided and policy models throughout the Fed often presented policy options by relating them to a Taylor rule. That complacency, of course, vanished with the financial crisis and the Great Recession that followed. But in a recent Brookings paper, Narayana Kocherlakota, an academic economist who had favored rules before becoming President of the Minneapolis Federal Reserve, concluded that the attention to Taylor’s rule had kept the Fed’s initial response to the crisis from being as aggressive as it should have been. Even though there is little risk Congress would actually impose policy rules on monetary policy, it would be useful if rules received less attention than Kocherlakota tells us they now do.