The reason Hu Jintao decided to visit the U.S. this month is that the Chinese leader wants to know when the U.S. economy and its currency will be stable and strong again. It’s good the Chinese are known for patience because Hu may have to wait a while.
At least that’s the view according to John Taylor, a Stanford University economist who has influenced Federal Reserve policies in the past.
Fed officials often refer to the Taylor Rule, a formula devised by Taylor that shows how a central bank should manage interest rates in response to inflation and other data. At a recent joint lunch of the American Economics Association and the American Finance Association, Taylor, a Treasury undersecretary in President George W. Bush’s administration, delivered a second, equally interesting, rule.
Taylor Rule II doesn’t have math. And it doesn’t say what the Fed should do. It predicts what the central bank will do. Taylor says a period of less Fed intervention and stable strong growth will come, along with a strengthening dollar. But by the time this happens, Hu, now 68, might be approaching 80.
Taylor studied the past 60 years of U.S. policy, and found that the Fed moves in a pendulum pattern, swinging back and forth between discretion-based decisions and loose money on one hand and rules-based choices and tighter money on the other.
Following World War II, many policy makers worried that the Fed would serve as a perpetual monetary handmaiden to Congress and the president as they pursued interventionist and Keynesian policies, including targeting interest rates.
Scene From ‘50s
Winthrop Aldrich, then president of Chase National Bank, said in 1948 that the Fed shouldn’t be in the business of supporting the market for U.S. Treasuries and should “modify the policy of maintaining rigid support levels of government bonds.” In 1951 the Fed negotiated a public accord with Treasury that made clear its position that the central bank could follow its own interest-rate rules.
For the Fed to thumb its nose at Treasury was not as easy as it sounds. In 1950, unemployment was rising and the Korean War began. China’s involvement in U.S. affairs was on a whole other level. Chinese soldiers were pouring into Korea, forcing U.S. troops to retreat. Yet the Fed had enough support among lawmakers to make its declaration. Economist Allan Meltzer chronicles some of this in his indispensable two-volume “A History of the Federal Reserve.”
In the 1960s and 1970s, the Fed moved back toward discretion-based policies. Along with that came cooperation with the Treasury. As Taylor notes in his presentation, this basically meant looser money, and a “series of boom-bust cycles in monetary policy with the inflation rate rising steadily higher at each cycle.”
This discretionary period reached its peak in 1973 when then-Fed Chairman Arthur Burns argued that “wage rates and prices no longer respond as they once did to the play of market forces.” The central bank did respond to inflation, but not systematically. The outcome was the stagflation of the 1970s, a period when communist regimes started noticing the U.S. could be vulnerable.
Rules became fashionable again in the 1980s and 1990s, beginning with the arrival of Paul Volcker as Fed chairman in 1979. Volcker emphasized monetarist methods for controlling money. Though the bank struggled with which rules to follow, the central bankers made it clear they didn’t like ad hoc behavior or inflation.
The Fed, Taylor says, began to announce its interest-rate decisions immediately after making them, and explaining its intentions regarding the future. This transparency itself sent a signal: the Fed’s moves and its direction are less arbitrary than in the past.
A look at the first decade and a half of Alan Greenspan’s tenure as chairman of the central bank shows it setting the Fed funds rate at levels consistent with the original Taylor Rule. Fiscal policy in these years likewise became less discretionary.
“There is now widespread agreement that counter-cyclical discretionary fiscal policy is neither desirable nor politically feasible,” wrote economist Martin Eichenbaum in April 1997.
Taylor sees this consensus on the value of stability as one of the causes for the moderation of the business cycle.
After 2002 or so, however, the central bank began to diverge from the Taylor Rule, keeping the Fed funds rate lower than the rule warranted. It also initiated two rounds of quantitative easing.
Move Toward Discretion
Overall, Taylor discerns “a clear positive correlation between rules-based policy and good economic performance.” He sees the rules causing the growth.
But what if the mechanism works the other way, with poor performance by the general economy provoking the Fed into action? The timing does not back up this Fed activism-in-a- crisis thesis.
“In the 1960s and 1970s the Fed moved toward discretion long before the stagflation,” Taylor says. In the decade just completed, the Fed moved toward discretion well before the 2008 crash.
Soon after Hu heads back to China, Congress will be writing new Fed law. Some legislators want to follow the advice of Dallas Fed President Richard Fisher and change the statute governing the Fed to narrow its discretion and restrict its job to controlling inflation. Such a law might speed up the Taylor cycle in a fashion welcome to anyone investing in the U.S.
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