Yellen ally pours cold wa­ter on rule-based mon­e­tary pol­icy

The Pak Banker - - COMPANIES/BOSS -

For much of her ten­ure as head of the Fed­eral Re­serve, Janet Yellen has been pres­sured by Repub­li­can law­mak­ers who want the US cen­tral bank to adopt a mon­e­tary pol­icy rule, a straight­for­ward for­mula con­nect­ing un­em­ploy­ment and in­fla­tion to a bench­mark in­ter­est rate.

On Satur­day a Yellen ally and for­mer ad­viser at the Fed de­liv­ered a provoca­tive re­tort: the eco­nomic mod­els un­der­pin­ning those sim­ple rules don't work that well, and the best pol­icy de­ci­sions come when cen­tral bankers look be­yond those mod­els to the un­ex­pected econ­omy.

For­mer Fed Chair Alan Greenspan fa­mously did it in the 1990s when he ar­gued against a rate hike at a time when ris­ing pro­duc­tiv­ity was hold­ing down in­fla­tion, and ar­guably failed to do it when he ig­nored the im­pact of the tech and hous­ing bub­bles, Johns Hop­kins Univer­sity eco­nom­ics pro­fes­sor Jon Faust said in a pa­per pre­sented at an an­nual Fed con­fer­ence here.

In each case the point is the same: it was the ex­tra­or­di­nary events out­side of the ba­sic in­fla­tion and out­put mod­els used

forces shap­ing

the by cen­tral bankers that ul­ti­mately mat­tered most, ar­gued Faust, who served as a spe­cial ad­viser to the Fed's board of gover­nors un­til Septem­ber 2014.

That ap­proach "brings fears of 'seatof-the-pants' pol­i­cy­mak­ing and, for the more ex­citable, of bar­bar­ians at the cen­tral bank gates," Faust wrote.

But af­ter re­view­ing the sta­tis­ti­cal mod­els that try to sep­a­rate un­der­ly­ing eco­nomic trends from other fac­tors, Faust said he con­cluded it is those other fac­tors that pol­i­cy­mak­ers of­ten need to un­der­stand and re­flect in their de­ci­sions - some­thing that can't be done through a rule. "Nor­mal cycli­cal dy­nam­ics ... have played a dis­tinctly mi­nor role in both the suc­cesses and fail­ures" of mon­e­tary pol­icy, Faust wrote.

"Un­der­stand­ing ... con­found­ing dy­nam­ics has al­ways been the key to good pol­i­cy­mak­ing and fail­ure to un­der­stand those dy­nam­ics has played a key role in ma­jor pol­icy mis­takes."

So­phis­ti­cated econo­met­ric mod­els of in­fla­tion, for ex­am­ple, may in­clude "ex­tra wiggles" in the forecast as in­fla­tion moves from its cur­rent rate to a long-run av­er­age, but on the whole do no bet­ter than a "mind­less" line drawn be­tween the two points, he said.

His ar­gu­ment has bear­ing for the push by Repub­li­cans in Congress and pos­si­bly by the party's even­tual 2016 pres­i­den­tial nom­i­nee to tie the Fed to a pol­icy rule.

Yellen is ar­guably fac­ing a "seat-ofthe- pants" mo­ment now in judg­ing whether it is time to raise rates, a call tied closely to her judg­ment about when and how fast in­fla­tion might rise to the Fed's 2 per­cent tar­get. That's a de­ci­sion no model or rule will help with, Faust sug­gested. "Pol­i­cy­mak­ers must take a stand," he said.

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