Taylor Is Questioning His Own Rule

A candidate to be Fed chairman recently acknowledged that circumstances might cause the Fed to deviate from the guidelines' prescriptions.

Taylor is flexible.

Photographer: Andrew Harrer/Bloomberg

Some members of Congress are trying, once again, to pass legislation to strip the Federal Reserve of discretion over how it manages monetary policy and to force it to adhere to rules instead. A measure has passed in the House that would require the Fed to follow a Taylor rule, named after Professor John Taylor of Stanford University, for adjusting policy interest rates. So it was extremely interesting to listen to Taylor, a candidate to be the next Fed chairman, make the case on behalf of his rule at the Boston Fed conference last week. It didn’t sell well, except to its previous supporters.

The Taylor rule ties changes in interest rates to how far unemployment and inflation deviate from their policy objectives. When unemployment is above target, or inflation below target, the guideline requires policy rates to be reduced to levels that would stimulate growth. This is, of course, precisely what the Fed has used its discretion over policy to implement. Taylor warrants that policy would be more transparent, predictable, accountable and effective if only the central bank rigidly followed his rule instead of adjusting policy based on the judgment of the Open Market Committee of the economy’s policy needs. It would give investors the ability to know well in advance precisely how policy would respond to changes in unemployment or inflation. The Fed would become more accountable, since it would be clear to all observers when it deviated from the rule. And according to Taylor, the policy results would be better, with the economy enjoying smaller deviations of unemployment or inflation from their targets.

Many objections to Taylor’s policy prescription were raised at the conference. What if the financial system was taking on too much risk, as occurred prior to the credit crisis in 2008? Should the Fed ignore this behavior and keep policy rates at their rule-proscribed levels? The rule would not permit a policy response. What if the rule instructions are wrong, as has seemingly recently been the case with the Phillips curve shifting? Some argue, with hindsight, that the pace of the recovery that began in 2009 was too slow because the Fed was insufficiently aggressive in reducing interest rates. How long should the bank stick to the rule’s incorrect results before applying discretion to change it? What if the corporate sector becomes too complacent and leverages up excessively? Should the Fed ignore this and leave rates at their prevailing settings? What if the dollar declines in value, boosting foreign demand for U.S. production and elevating growth? The rule would not respond to any of these developments until they cause unemployment or inflation to move away from policy objectives. But if the Fed could operate with discretion, it could act more promptly to adjust policy appropriate to the unanticipated changing economic conditions.

The oddest objection to the rule was raised by Taylor himself. After making his case for implementation, he acknowledged that assorted circumstances might provide good cause for the Fed to deviate from the rule’s prescriptions. In fact, he said “discretion is inherently needed” for policy makers. In doing so, Taylor straddled the rule-versus-discretion debate, even as he supported adoption of his precept. Uncharitably, one could say that Taylor wants his cake and to eat it, too. Of course, no rule can possibly anticipate all of the developments that might arise that could affect the economy undesirably. Given all the possibilities, perhaps it was not surprising that there was only limited support for implementing a Taylor rule.

Even so, there is serious consideration in Congress for imposing some sort of operating rule on the Fed. That push may be motivated by the desire to make the bank more accountable to Congress because it is deemed too independent, its officials aren’t elected, and its policy decisions may be difficult to explain. Yet the central bank reports directly to Congress, which has the authority to change its rules of operation at any time. And Congress has periodically changed its instructions, mostly by requiring more reporting, including that the chair testify on a regular basis. Still, without formal policy rules, it is difficult for Congress to object strongly to whatever policy the Fed chooses to implement. But do we really want the legislature to be establishing the rules for running monetary policy?

Congress is deeply divided along partisan lines, and political considerations would inevitably enter into how its members view whether the Fed is implementing the appropriate policy. Members of the party out of power tend to object to any policy that supports the administration’s objectives. Indeed, political divisions within Congress have long been behind many of the criticisms of the central bank. Chair Janet Yellen and her predecessors have placidly sat in hearings, listened attentively and responded to the questions and objections of members of Congress and explained policy decisions in detail. Then the Fed chair goes back to the real job of policy making. That policy independence clearly rankles some lawmakers, who would prefer to exert congressional control. But the economy would suffer, probably badly, if Congress instructed the Fed how to run monetary policy. It is perfectly fine for Congress to set the objectives for policy, such as reducing unemployment or keeping inflation low, but the legislative branch should avoid telling the Fed how to do its job.

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