Fallible Fed Needs a Few Good Rules
The top question at the Federal Reserve, and for Fed watchers around the world, is when will it raise interest rates. For months, the central bank has been signaling that -- as the effects of the financial crisis finally start to ebb -- it will act soon, perhaps as early as September. Alan Blinder, a former Fed vice chairman, says everyone is paying too much attention to the question of timing.
So let’s focus some of that attention on two other issues that ought to be before the Fed. One concerns the policy framework within which it makes its moves on interest rates; the other, the way it communicates those moves.
Tightening monetary policy by raising interest rates could make sense in today’s economy, depending on the Fed’s overall objectives. It’s a peculiar move, though, in the context of the Fed’s announced goals of minimizing unemployment and hitting a 2 percent goal for inflation. Inflation is running below 2 percent, and as Blinder notes, the Fed itself does not expect it to rise to 2 percent until 2017.
Some Republicans think that Congress should supply a framework for the Fed, making it more rule-bound. One much-discussed approach would have the Fed follow the “Taylor rule” -- named after John Taylor, a Stanford economist -- which says that the federal funds rate should be set according to a formula involving inflation, the long-run real interest rate, and the gap between the economy's actual output and its potential output. The Fed’s behavior might then be more predictable. It would raise and lower the fed funds rate according to the formula.
The Economist magazine recently criticized the idea of following a formula, arguing that the Taylor rule has drawbacks. It argued that the Fed should continue to exercise broad discretion over monetary policy.
But to say that a central bank acting on its own discretion could perform better than one following the Taylor rule doesn't mean that it is likely to do so. And the Taylor rule isn't the only possible rule. The Fed could instead act to keep the growth in nominal spending -- the total amount of dollars being spent each year on consumption and investment -- at a fixed percentage each year. That approach wouldn't require it to make confident estimates about the output gap or long-term interest rates. It would also lend itself to greater predictability, and a recent paper suggests that it might work better than either inflation-targeting or the Taylor rule, especially given uncertainty about those values.
Whether or not it adopts a nominal-spending rule, or any other rule, the Fed could also with minimal effort make its reasoning clearer. It should regularly produce and share its estimate of the short-term natural interest rate.
When the Fed wants to stimulate the economy, it tries to bring interest rates below their natural, or equilibrium, level. When it wants to restrain the economy, it tries to bring them above that level. But it doesn't plainly say what it thinks that level is.
Sharing an estimate, even if it covers a range, could actually make the Fed's job easier. Over the past few years, for example, the Fed has been accused of punishing savers and engaging in "financial repression" by holding interest rates low. But its actions were clearly premised on the idea that the natural interest rate at the trough of the recession was negative. Saying so would have offered some perspective on whether Fed policy was really as loose as it was generally taken to be, as economist David Beckworth has argued. It would also have made clear that the state of the economy, not the Fed's policies, were to blame for the low return on savings.
That wouldn't have gotten the Fed completely off the hook because its policies influence that natural rate. But publishing such estimates would help to clarify the debate over its past and future decisions. (Beckworth and I expand on these points here.)
It is unlikely that the Fed, in the near term, will either adopt a nominal-spending target or produce estimates of the natural interest rate in real time. The central bank is slow to change and insulated from pressure. But the Fed doesn't have an especially good track record, either over the course of its history or in recent years. That’s a reason for changing some of its practices and for lashing the Fed’s fallible human governors to a well-considered rule.
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