Don't box her in.

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Binding the Fed Won't Help the Economy

Frederic S. Mishkin is a professor at Columbia University's Graduate School of Business, and a former governor of the Federal Reserve System.
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When Federal Reserve Chair Janet Yellen delivered her semiannual testimony to Congress this month, lawmakers once again expressed concern that the central bank was insufficiently transparent and may be pursing an over-expansionary monetary policy that could lead to high inflation.

This was but the latest round of questions about the Fed's considerable discretion to take actions such as adjusting the federal funds rate without interference from Congress or the President. Late last year, a bill passed the House that would require the central bank to abide by a so-called policy-instrument rule and set its policy instrument based on certain available data, including inflation, gross domestic product and unemployment.

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Would such a rule produce better economic outcomes? The answer is no, for four reasons:

First, for the constraint to be effective, policy makers must have a reliable model of the economy. For example, a successful policy-instrument rule would require the central bank to have confidence in the accuracy of the measure used to ensure that the unemployment rate isn't contributing to either increases or declines in inflation. Unfortunately, research has shown that the metric most often used for the calculation -- the non-accelerating inflation rate of unemployment, or NAIRU -- delivers highly uncertain results.  Indeed, the instances of very high inflation in the U.S. in the 1970s were due to Fed policy makers' belief that the NAIRU was around 4 percent, when it actually was closer to 6 percent. Based on this faulty information, the Fed did not pursue contractionary monetary policy when the unemployment rate fell below 6 percent, as it should have, leading to an upward spiral in inflation.

Second, a policy-instrument rule would remain valid only so long as the structure of the economy didn't undergo substantial changes. The failure of past monetary targeting in many countries demonstrated the dangers. In 1980, the Swiss National Bank set a growth rate target for a narrow monetary aggregate. When the country introduced a new interbank payment system in 1988, this structural change caused a severe drop in banks’ desired holdings of this narrow money because a smaller amount was now needed relative to overall spending in the economy. Adherence to the policy rule, however, caused the Swiss inflation rate to rise above 5 percent in 1990 and 1991, well above the prevailing levels in the rest of Western Europe.

Third, a policy-instrument rule can be too rigid because it cannot foresee every contingency. This was made clear in the recent financial crisis: Almost no one could have predicted that problems in one small part of the system -- subprime mortgage lending -- would lead to the worst meltdown since the Great Depression. The unprecedented monetary policy that the Fed undertook to prevent the crisis from escalating, perhaps even leading to a depression, could not have been written into a policy rule ahead of time.

For example, the Fed cut the federal funds rate starting in the third quarter of 2007, when any reasonable policy rule would have argued against this course of action -- that is, when inflation was rising and real GDP growth was strong. Indeed, in hindsight, the Fed should have pursued more expansionary monetary policy even earlier: The recession would then have been less severe and inflation would have stayed closer to 2 percent, the central bank's current objective for the inflation rate.

Fourth, a policy-instrument rule does not easily incorporate the need to use judgment. Monetary policy is as much art as science. Central bankers need to look at a wide range of information to decide on the best course, and some of this information is not easily quantifiable, making judgment a critical element of success. 

Yet even though a policy-instrument rule won't ensure the best results, that doesn't mean that central banks should have complete discretion, which can be undisciplined, non-transparent and lead to poor economic outcomes.

One way that central banks have constrained discretion is by adopting a numerical target for the inflation rate. Although it acted later than others, the Fed finally set a 2 percent inflation objective in January 2012. Central banks that use inflation targeting have substantially increased the transparency of monetary policy by providing more information about their actions, allowing the public and politicians to evaluate whether they are acting and will act appropriately.

The Fed needs to enhance the transparency of its monetary policy actions, but a policy-instrument rule is not the way to do it.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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Frederic S Mishkin at

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Max Berley at