Fed Officials Weigh Rules-Based Policy That Stay Flexible

U.S. Federal Reserve Vice Chairman Janet Yellen
Janet Yellen, vice chairman of the U.S. Federal Reserve. Photographer: Jin Lee/Bloomberg

Federal Reserve officials are struggling to find consensus on a policy rule that’s predictable to investors yet flexible enough to adjust to shifts in the economy or markets.

Vice Chairman Janet Yellen and Philadelphia Fed President Charles Plosser this month said rules like one created by Stanford University’s John B. Taylor may help central bankers avoid the impression that they are improvising. “Setting monetary policy in a systematic or rule-like manner leads to better economic outcomes,” Plosser said in an April 12 speech.

Fed officials can’t afford to surprise investors and cause a market disruption that impedes growth or spurs inflation, said former St. Louis Fed President William Poole. At the same time, any policy rule risks tying the hands of Fed officials should the economy suddenly veer from their forecasts.

“The trade-off is between the ideal of rules-based policy and the reality of a messy world,” said Michael Feroli, chief U.S. economist for JPMorgan Chase & Co. in New York and a former Fed economist. The Federal Open Market Committee “appears to be groping its way toward finding the right trade-off.”

The policy-setting panel will probably repeat in a statement today that subdued inflation and economic slack will result in “exceptionally low” interest rates through at least late 2014, economists said. The statement is due around 12:30 p.m. in Washington.

The Fed at 2 p.m. will release policy makers’ forecasts for growth, unemployment, inflation and the appropriate path of the federal funds rate over the next several years. Chairman Ben S. Bernanke plans to hold a press conference at 2:15 p.m.

Systematic Approach

Taylor argued that the economy fares better when policy makers pursue a systematic approach that reduces the chances of error. His rule, developed in 1993, sets the main interest rate based on the rate of inflation and the gap between the economy’s potential and actual level of output.

Poole favors such a rule because it would make policy more predictable. He said repairing damage from a miscommunication would be particularly challenging after the Fed cut its main interest rate to zero and expanded its balance sheet to $2.88 trillion.

“It ought not to appear that policy comes from a coin flip, or is chosen from a table of random numbers,” Poole, senior economic adviser to Merk Investments LLC in Palo Alto, California, said in an interview. An unpredictable approach leads to “economic inefficiencies and more market volatility,” he said. “That is the way it appears today.”

August Statement

Poole cited the Fed’s Aug. 9 statement that it would keep its main interest rate low through mid-2013, a date that has since been pushed back by the committee. The yield on the 10-year Treasury note fell to 2.11 percent on the day after the statement from 2.32 percent the day before.

In an April 20 speech, Poole said the announcement “seemed to come out of left” field. Plosser, who backs the idea of a policy rule, said that with 17 members, the FOMC may not be ready to reach a consensus.

“I suspect that the FOMC participants are not ready to agree on a specific policy rule or reaction function because they use different models,” Plosser said in an April 12 speech.

Until they adopt a rule, Fed officials should agree on a set of economic variables that they would observe when setting policy, Plosser said.

“If we choose a consistent set of variables and systematically use them to describe our policy choices, the public will form more accurate judgments about the likely course of policy, thereby reducing uncertainty and promoting stability,” Plosser said.

‘Suite’ of Rules

James Bullard, president of the Fed bank of St. Louis, told reporters after an April 16 speech that he determines the FOMC’s best way forward by reviewing “a suite of policy rules” while focusing on the rate of economic growth.

The Chicago Fed’s Charles Evans has suggested the Fed refrain from tightening policy until unemployment falls below 7 percent or inflation exceeds 3 percent.

“The Fed uses rules to provide a benchmark for policy discussions as opposed to a mechanical formula to run policy,” said Mark Gertler, an economics professor at New York University who has co-written research with Bernanke.

“There are too many factors unknowable in advance to turn policy over to a mechanical rule,” he said. “At the same time, I think laying out the basic criteria for when the Fed is likely to add or withdraw stimulus is useful.”

Inflation Target

Plosser joined Bernanke in calling on the Fed to create an inflation target, which the FOMC adopted in January by setting a 2 percent objective for price increases.

“Plosser has been effective in pushing his agenda toward at least getting more rules,” said Robert Brusca, chief economist at Fact & Opinion Economics in New York.

Fed Vice Chairman Yellen, in an April 11 speech, said that while rules are “helpful in evaluating the stance of policy,” it would be “imprudent to adhere mechanistically to the prescription of any single policy rule.”

She said that applying the Taylor rule today would mean the Fed should raise its benchmark interest rate, now close to zero, in 2013. That’s in contrast to the Fed’s view that rates should stay low at least through late 2014.

Yellen said she favors a variant of the Taylor rule focusing on growth and indicating rates should remain near zero until early 2015. She said the variant “is more consistent with following a balanced approach to promoting our dual mandate” for price stability and maximum employment.

Calculations Disputed

Taylor disputed Yellen’s calculations in a commentary on his website, saying the rule currently implies a federal funds rate of 1 percent or higher. He also disassociated himself from Yellen’s variation of his model, saying her approach focuses too much on economic slack and could be used to support more asset purchases by the central bank.

Regardless of their differences over a policy rule, Fed officials probably won’t shift much today from their prior statement on March 13, economists said. Yields on benchmark 10-year Treasury notes were at 1.97 percent yesterday, close to an eight-week low, amid speculation the FOMC will keep borrowing rates at record lows.

Policy makers will probably revise down their forecasts for unemployment following a drop in the jobless rate, and growth may show “a small tick up,” Feroli said.

Jeff Kearns in Washington at jkearns3@bloomberg.net

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