Bind­ing the Fed won’t help the econ­omy

The Pak Banker - - OPINION - Fred­eric S. Mishkin

WHEN Fed­eral Re­serve Chair Janet Yellen de­liv­ered her semi­an­nual tes­ti­mony to Congress this month, law­mak­ers once again ex­pressed­con­cern 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. 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 the­in­fla­tion 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.

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