Policy Debate: Should the Fed pursue a fixed policy rule?

The uncertainties implicit in using any rule of thumb, however well it might have performed in the past, are probably sufficient that policy-makers should retain their discretion. There can also be periods when the Fed is pursuing multiple goals. At the same time, the science of rule-building may have advanced to the point where monetary rules of thumb might play some useful role in the conduct of monetary policy. Myriad short term uncertainties and special factors mean that rules still cannot deal with many ad hoc situations. But in view of the deeper uncertainties about how hard monetary authorities should lean against what wind, rules of thumb might give good guidance to policy-makers. They might help authorities avoid large and persistent mistakes. Rather than replacing judgment, in the end rules may aid judgment.
~ Edward M. Gramlich

Until the Great Depression, most economists argued that the government should provide a stable economic infrastructure, but should not engage in attempts to stabilize the economy. Classical economic models suggested that the economy was self-equilibrating and tended to move toward a full-employment equilibrium relatively rapidly. These models suggested that there was no need for governments to engage in activist fiscal or monetary policies. The experience of the Great Depression, however, caused many economists to re-evaluate these models and policy recommendations.

In this environment, John Maynard Keynes published The General Theory in 1936. He argued that the government should engage in discretionary fiscal and monetary policies designed to shift the economy toward a full-employment equilibrium. While Keynes accepted the argument that an economy experiencing a severe recession or depression may eventually move towards a full-employment equilibrium in the long run, he argued that this adjustment process could require a good deal of time. In a famous quote, Keynes noted that, "In the long run, we're all dead." Keynes' arguments were rapidly accepted by the economics profession and provided a theoretical basis for activist fiscal and monetary policies.

By the 1950s and early 1960s, Keynesian economic models and policy prescriptions were generally accepted by policymakers. These policies appeared to be quite successful when used to stimulate the economy. The primary focus of macroeconomic policy during this period was on avoiding a recurrence of a severe recession. Little emphasis was placed on inflation since it was believed that the costs of inflation were relatively low. Advocates of Keynesian policies believed that it was possible to use discretionary fiscal and monetary policy to "fine-tune" the economy, achieving full employment with only a moderate amount of inflation.

As long as unemployment and inflation rates both remained low, there was little reason to question the use of discretionary policies. Increased government expenditures related to both the Vietnam War and the "war on poverty" resulted in greater inflationary pressures in the U.S. during the mid- and late-1960s. The Arab Oil embargoes of the early 1970s resulted in further inflationary pressures. This inflation, however, unlike other recent periods of inflation, was accompanied by rising unemployment rates. This "stagflation," as it came to be known, could not be explained by the simple Keynesian models that were in general use during this period.

Milton Friedman, and other monetarists, were quite willing to provide an alternative explanation for these phenomena. Friedman argued that discretionary policies could have a short-run effect on the level of output. Monetarists argue, however, that the economy, left to itself, will move to a full-employment equilibrium quite rapidly. Thus, discretionary policy changes will not be able to influence the level of output in the long run. According to the monetarists, changes in the money supply supply will only affect the price level in the long run. Friedman argued that the growing inflation rate experienced during these periods was due to an attempt to maintain a level of unemployment that is below the "natural rate of unemployment," the rate of unemployment that was consistent with price stability. While Friedman believed that discretionary policy has an affect on the economy, he argued that the actual effect was more often the reverse of the desirable effect because of the existence of lags in:

• recognizing the need for a policy change,
• implementing the new policy, and
• the effect of the policy on the economy.

Robert Lucas, Thomas Sargent, Neil Wallace, and other "new-classical economists" provided an alternative critique of discretionary fiscal and monetary policies. This critique relies on the concept of "rational expectations." Individuals that possess rational expectations take all available information into account in predicting future outcomes. If individuals possess rational expectations, discretionary monetary and fiscal policy changes that are anticipated by the public will cease to have an effect on unemployment. If everyone believes, for example that a monetary expansion will occur that will result in 5% inflation next period, wages and contracts negotiated today will include a 5% adjustment for the anticipated inflation. Under this model, monetary policy changes that are anticipated will only affect the price level and will not effect unemployment in the short run. While a faster than expected growth in the money supply may reduce unemployment in the short run, such a "surprise" ceases to surprise people if it is occurs often enough.

New classical economists, therefore, agree with monetarists in supporting a fixed monetary policy rule. They generally advocate a fixed money growth rate rule and argue that low inflation is likely to result only if the Fed announces, and maintains, such a policy. While the Fed may be able to lower unemployment, in the short run, by an unexpectedly large increase in the money supply, the use of such a policy would make the Fed's subsequent announcements less credible and would encourage higher future inflation rates.

New Keynesian economists, on the other hand, follow in the Keynesian tradition of advocating discretionary monetary (and fiscal) policies. While they differ from earlier Keynesians in placing greater emphasis on the role of aggregate supply, they share a belief that the economy, left to itself, often adjusts relatively slowly. New Keynesians believe that the appropriate use of discretionary monetary and fiscal policies may reduce the costs associated with recession or periods of high inflation.

Another area of contention concerns the choice of a policy rule. One type of rule is a fixed money growth rule (as advocated by many monetarists and new classical economists) that requires a constant (and low) rate of growth in the money supply without regard to economic circumstances. At the other extreme are rules that vary the rate of monetary growth according to realized inflation and unemployment rates according to a predetermined formula.

Related materials may be found in the debate that examines whether the Fed should pursue a zero inflation target.

• Rebecca Hellerstein, "The Impact of Inflation"
  http://www.bos.frb.org/economic/nerr/rr1997/winter/hell97_1.htm
  In this Boston Fed online article, Rebecca Hellerstein provides a good discussion of the actual and perceived economic costs of inflation. This article summarizes a large volume of relatively technical recent studies in a very simple manner.

• Alan S. Blinder, "The Strategy of Monetary Policy"
  http://minneapolisfed.org/pubs/region/95-09/reg959a.cfm
  In this September 1995 article, Alan S. Blinder, the Vice Chairman of the Federal Reserve Board of Governors, discusses practical problems in the conduct of monetary policy. Blinder provides a good summary of the measurement issues making it difficult to achieve monetary targets and examines the difficulties of conducting monetary policy in an uncertain environment.

• Bank for International Settlements, "Central Bank Websites"
  http://www.bis.org/cbanks.htm
  This web site contain links to the websites of virtually all central banks that maintain an internet presence. These web sites often contain information about the conduct of monetary policy in these countries.

• Owen F. Humpage, "Monetary Policy and Real Economic Growth"
  http://www.clevelandfed.org/Research/Com96/1296.htm
  Owen Humpage discusses the short- and long-run relationships that are expected to exist between the rate of growth in the money supply and the rate of economic growth. He provides a good intuitive discussion of both the relevant economic theory and the empirical evidence concerning these relationships.

• Carl E. Walsh, "The New Output-Inflation Trade-off"
  http://www.frbsf.org/econrsrch/wklyltr/wklyltr98/el98-04.html
  In this online Federal Reserve Bank of San Francisco publication, Carl E. Walsh summarizes the areas of agreement and disagreement concerning the relationship between changes in the money supply and changes in real output in the short run and in the long run. He notes that there is general agreement that monetary policy has no effect on the level of real output in the long run. Walsh argues that recent research focuses on a tradeoff between variability in output and variability in inflation.

• Federal Reserve District Banks
  http://www.oswego.edu/~economic/fed.htm
  This page contains a list of links to the home pages of Federal Reserve District Bank web sites. Each of these sites contains online articles that discuss the conduct of monetary policy.

• Joint Economic Committee, "Establishing Federal Reserve Inflation Goals"
  http://www.house.gov/jec/fed/fed/goals.htm
  In this April 1997 study, the Joint Economic Committee recommends the adoption of a price stability target for the Fed. The committee argues that such a policy would help preserve the Fed's credibility and would encourage economic growth.

• Antonio Martino, "Monetary and Fiscal Rules"
  http://www.cis.org.au/Policy/autumn98/aut9801.htm
  Antonio Martino provides a summary of the arguments in support of a fixed monetary rule in this online article appearing in Policy (Autumn, 1998). He provides an excellent nontechnical summary of the evolution of the economic debate concerning the use of a fixed monetary rule from the 1930s to the present day. Martino notes that while a large proportion of economists support the use of a monetary rule, there is substantial disagreement over which rule should be applied. Martino discusses problems with a variety of monetary rules are discussed in this article.

• Giandomenico Majone, "Temporal Consistency and Policy Credibility: Why Democracies Need Non-Majoritarian Institutions"
  http://www.iue.it/RSCAS/WP-Texts/96_57.html
  In this European University Institute Working Paper, Giandomenico Majone examines why democratically elected governments generally rely on autonomous agencies to control their monetary policy. Majone argues that this is done primarily so that monetary policy announcements remain credible. He argues that democratically elected governments engaging in discretionary monetary policy often face incentives that encourage them to alter monetary policy from previously announced objectives. This problem of "time inconsistency" results in a loss of credibility. With a loss in credibility, it becomes difficult for monetary policymakers to achieve policy objectives. Independent monetary policy agencies, however, are able to focus on longer term objectives and are more likely to engage in monetary policies that are time consistent.

• Edward M. Gramlich, "Monetary Rules"
  http://www.federalreserve.gov/boarddocs/speeches/199802272.htm
  Federal Reserve Board Governor Edward M. Gramlich discusses alternative monetary policy rules at the Eastern Economic Association's Samuelson Lecture held February 27, 1998. He discusses the advantages and disadvantages of a variety of policy rules including: a gold standard, a constant rate of monetary growth rule, inflation targeting, and Taylor's rule (this rule incorporates a feedback effect in which the policy is automatically adjusted when the inflation rate and/or real GDP diverges from their target levels). Gramlich argues that Taylor's rule seems to perform the best, but argues that policymakers should maintain discretion in implementing monetary policy. He suggests that rules should be used to aid, but not replace, judgment in establishing monetary policy.

• Otmar Issing, "Monetary Theory as a Basis for Monetary Policy: Reflections of a Central Banker"
  http://www.internetional.se/issingitaly.htm
  Otmar Issing, a Member of the Board of the Deutsche Bundesbank, argues that monetary theory does not provide an adequate basis to guide central bankers in the day-to-day conduct of monetary policy. He notes that macroeconomic theorists often disagree, and many economic theories that were once generally accepted by economists were eventually proven to be wrong. Issing also notes that the public may respond to policy changes in ways that make it impossible to achieve the original policy objectives. He argues that there are problems associated with the use of either a fixed policy rule or a discretionary monetary policy. Issing recommends that policymakers must rely on both economic theory and practical experience in establishing monetary policy.

• Federal Reserve Bank of San Francisco, "What is Taylor's rule and what does is say about Federal Reserve monetary policy?"
  http://www.frbsf.org/education/activities/drecon/ask298.html
  This online document discusses the Taylor Rule, a policy rule suggested by John Taylor of Stanford University. It is noted that this rule provides a very close approximation to the policies that have been pursued by the Fed during Alan Greenspan's chairmanship.

• John Taylor, "The Taylor Rule"
  http://research.stlouisfed.org/conferences/homer/rule.html
  In this excerpt from Inflation, Unemployment, and Monetary Policy (MIT Press, 1998), John Taylor provides a simple statement of and justification for the Taylor Rule.

• John Taylor, "Monetary Policy Rule Home Page"
  http://www.stanford.edu/~johntayl/PolRulLink.htm
  John Taylor's Monetary Policy Rule Home Page contains links to a diverse and interesting collection of online monetary policy resources. In addition to links to papers and discussions that are designed for the general public, there is also a collection of links to more technical studies of the use of monetary policy rules. This is a superb place to visit for those interested in finding out more about monetary policy rules in theory and practice.

• Athanasios Orphanides, "Activist Stabilization Policy and Inflation: The Taylor Rule in the 1970s"
  http://www.federalreserve.gov/pubs/feds/2000/200013/200013pap.pdf
  In this February 2000 Federal Reserve Board working paper, Athanasios Orphanides shows that the behavior of the Fed during the 1970s was very close to the behavior suggested by the Taylor rule. Since the economic outcomes of this period are often viewed as being undesirable, he suggests that this may raise some questions concerning the usefulness of the Taylor rule. (The Adobe Acrobat viewer plugin is required to view this document. You may download this viewer by clicking here.)

• Kevin Dowd, "A Rule to Stabilize the Price Level"
  http://www.cato.org/pubs/journal/cj15n1-3.html
  In this Cato Journal article, Kevin Dowd argues that central banks should attempt to pursue a target of maintaining a stable price for a price-index futures contract. He argues that a commodity basket standard of money would be preferred to using a single commodity (such as gold) as a monetary standard. Dowd suggests that a price-index futures contract would have all of the advantages of using a commodity basket standard without the associated storage or handling costs.

• Nicholas Rowe and David Tulk, "A Simple Test of Simple Rules: Can They Improve How Monetary Policy is Implemented with Inflation Targets?"
  http://www.bankofcanada.ca/publications/working.papers/2003/wp03-31.pdf
  Nicholas Rowe and David Tulk examine the possible effect of alternative monetary policy rules in this October 2003 Bank of Canada Working Paper. They find that a variety of simple rules would not have improved the bank's performance in achieving inflation targets. (To view this document, the Adobe Acrobat viewer plugin is required. You may download this viewer by clicking here.)

• Carl E. Walsh, "Nobel Views on Inflation and Unemployment"
  http://www.frbsf.org/econrsrch/wklyltr/el97-01.html
  In this Federal Reserve Bank of San Francisco publication, Carl Walsh discusses the similarities and differences between the theoretical contributions and methodological approaches of Milton Friedman and Robert Lucas.

• Laurence H. Meyer, "The Global Economic Outlook and Challenges Facing Monetary Policy Around the World"
  http://www.federalreserve.gov/boarddocs/speeches/current/19990225.htm
  In this February 25, 1999 speech, Federal Reserve Governor Laurence H. Meyer discusses some of the problems associated with the conduct of monetary policy. He argues that in 1998 and early 1999, the Fed has allowed the federal funds rate to change from the level that would be suggested under the Taylor rule. He suggests that this departure from recent practice was due to recent changes in internal and external economic circumstances: the Russian default and devaluation, weaker foreign growth rates, and uncertainty about the natural rate of unemployment.

• Federal Reserve Bank of Minneapolis, "An Interview with Janet Yellen"
  http://minneapolisfed.org/pubs/region/95-06/int956.cfm
  In this June 1995 interview, Janet Yellen discusses some of the problems facing monetary authorities in trying to achieve goals of low unemployment and price stability. She emphasizes the complications that occur as a result of long time lags in the response of the economy to monetary policy changes.

• Federal Reserve Bank of Minneapolis, "An Interview with Milton Friedman"
  http://minneapolisfed.org/pubs/region/92-06/int926.cfm
  Milton Friedman was the 1976 recipient of the Nobel Prize in Economics. In this 1992 interview, Friedman states his views on the conduct of monetarist policy (and a variety of other topics). He suggests that the Fed has a very poor record in conducting discretionary monetary policy.

• Federal Reserve Bank of Minneapolis, "Interview with James Tobin"
  http://minneapolisfed.org/pubs/region/96-12/tobin.cfm
  James Tobin was the 1981 recipient of the Nobel Prize in Economics for his work on money demand. In this 1996 interview, Tobin states his views on monetary theory (as well as on other policy issues). He argues that in favor of discretionary policy in which the Fed considers both unemployment and inflation rates in establishing monetary policy. Tobin also argues that there should be more political control over the Fed.

• Federal Reserve Bank of Minneapolis, "Interview with Ben Bernanke"
  http://www.minneapolisfed.org/pubs/region/04-06/bernanke.cfm
  In this June 2004 interview, Ben Bernanke discusses his advocacy of an inflation-rate target. He observes that the Fed has already shifted most of its focus to targeting the inflation rate, since this is the only outcome that the Fed can control in the long run. Bernanke argues that the adoption of an explicit low-inflation target would help stabilize inflationary expectations and reduce macroeconomic instability. (A wide range of other macroeconomic topics are also discussed in this interview.)

• James Poole, "The Fed's Monetary Policy Rule"
  http://research.stlouisfed.org/publications/review/06/01/Poole.pdf
  William Poole, the President of the Federal Reserve Bank of St. Louis, discusses the Fed's monetary policy practice in this article appearing in the January/February 2006 issue of the Federal Reserve Bank of St. Louis Review. He argues that the Fed's behavior since 1995 has been quite predictable. Poole suggests that the Fed has been implicitly following a monetary policy rule that is similar to the Taylor rule. He notes, though, that this rule appears to be modified so that it does not change policy when there are transitory and anomalous shocks to inflation or employment. The rule also is abandoned when there is a need to respond to a crisis, as occurred with the Fed's responses to the collapse of Long Term Capital Management in 1998, the Y2K phenomenon, and the 9/11/01 terrorist attack. In each case, the Fed provided a temporary increase in reserves to maintain liquidity in the banking system. Poole describes the rule that the Fed has been following as the "Greenspan rule" and suggests that it has provided increased transparency and credibility that have allowed the Fed to maintain a low and stable inflation rate. (The Adobe Acrobat viewer plugin is required to view this document. You may download this viewer by clicking here.)