Fed needs a few good rules

The Pak Banker - - OPINION - Ramesh Ponnuru

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.

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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