Stanley Fischer argues for Central Bank Discretion

In a speech yesterday, Fischer says:

Today I will offer some observations on monetary policy rules and their place in decision-making by the Federal Open Market Committee (FOMC). I have two messages. First, policymakers should consult the prescriptions of policy rules, but–almost needless to say–they should avoid applying them mechanically. Second, policymaking committees have strengths that policy rules lack. In particular, committees are an efficient means of aggregating a wide variety of information and perspectives.

Subsequently, John Taylor’s research, especially his celebrated 1993 paper, was a catalyst in changing the focus toward rules for the short-term interest rate.

Taylor’s work thus helped shift the terms of the discussion in favor of rules for the instrument that central banks prefer to use.

The research literature on monetary policy rules has experienced a major revival since Taylor’s seminal paper and has concentrated on rules for the short-term interest rate.

And concludes:

Let me now sum up. The prescriptions of monetary policy rules play a prominent role in the FOMC’s monetary policy deliberations. And this is as it should be, in view of the usefulness of rules as a starting point for policy discussion and the fact that comparison with a benchmark rule provides a useful means of articulating one’s own preferred policy action.

But, for the reasons I have outlined, adherence to a simple policy rule is not the most appropriate means of achieving macroeconomic goals–and there are very good reasons why monetary policy decisions are typically made in committees whose structure allows them to assess the varying conditions of different regions and economic sectors, as well as to reflect different beliefs about the working of the economy.

In essence, he argues that a better alternative to instrument rules is discretion, or “rules” by committee. He never considered the alternative of “target rules”, instead of “instrument rules”.

It seems that´s also Yellen´s view. Two years ago, at a Senate Banking Committee hearing, she said:


Interestingly, Yellen says that the Fed shouldn´t “be chained to any rule whatsoever”. Why? Because monetary policy requires “sound judgment”? And rules won´t provide that?

Maybe that´s a problem associated with “instrument rules” like Taylor-type rules, which give out the “desired” setting for the interest rate instrument (the FF target rate in the case of the US). What if the central bank, instead of an “instrument rule”, adopted a “target rule”?  For concreteness, let´s assume the Fed had adopted (maybe implicitly) a NGDP level target as it´s rule for monetary policy.

The charts compare and contrast the interest rate “policy rule” and the NGDP level target rule (where the “target (trend) level” is the “Great Moderation” (1987-05) trend). In this comparison, the actual setting of the Federal Funds (FF) rate is “right or wrong” depending on, not if it agrees with the setting “suggested” by the instrument rule, but if it is the rate that keeps NGDP close to the target path; and in case there is a deviation from the path, if the (re)setting drives NGDP back to the target.

For the “instrument rule”, I use the Mankiw version of the Taylor rule. The Mankiw version is simpler because it doesn´t require the estimation of an output gap and doesn´t state an inflation target rate (which the Fed didn´t have any way until January 2012).

The first chart shows John Taylor´s chart from his original 1993 paper. Note that it is qualitative (even if not exactly quantitative) similar to the “policy rule” obtained with the Mankiw rule.

During this period (1987 – 1992) monetary policy was “quite good”, in the sense of keeping NGDP close to the “target path”. Actually, when the Fed reduced the FF rate at the time of the stock market crash, it turned monetary policy a bit too expansionary, given NGDP went a bit above trend.

The next period covers 1993 – 1997. This is the core period of the “Great Moderation”. At the end of 1992, the FF rate had been reduced to 3%, a level which was maintained throughout 1993. According to the “policy rule” this was “too low”. With respect to the “target rule”, the FF rate was “just right”.

All through those years, NGDP remained very close to the “target path”, although the FF rate at times differed significantly from the “policy rule”.

The next period, 1998 – 2003.II is pretty damaging to the “policy rule” advocates. Taylor likes to say that the 2002 – 2005 period was one of “rates too low for too long” (having responsibility for the crash that came later).

What the chart tells us, however, is very different. The FF rate was too low in 1998 – 99. At this time, the Fed reacted to the Russia crisis (and the LTCM affair). Monetary policy loosened up at the same time that the economy was being buffeted by a positive productivity shock.

The monetary tightening that followed was a bit too strong because NGDP dropped below trend. The downward adjustment of the FF rate was correct in the sense that it stopped NGDP from falling lower, and by mid-2002 it began to recover. I wonder how much more grief the economy would have been subjected to if the “policy rule” had been followed.

The 2003.III – 2005 period is the second half of Taylor´s “too low for too long”. In the FOMC meeting of August 2003, the Fed adopted “forward guidance” (FG) (first it was “rates will remain low for a considerable period” followed by “will be patient to reduce accommodation, and finally “rates will rise at a measured pace”).  The fact is that FG helped push NGDP back to trend. Maybe the “pace was too measured”, but the fact is that by the time he handed the Fed to Bernanke, NGDP was square back on trend.

If the “policy rule” had been closely adhered to, the “Great Recession” would likely have happened sooner!

Now we come to see how the Fed botched monetary policy (likely due to Bernanke´s preferred inflation targeting monetary policy regime).

The FF rate remained at the high level it had reached at the end of the “measured pace story”. At the end of 2006, aggregate demand (NGDP) began to deviate, at first slowly, below the trend level. The FF rate remained put (notice that although too high, the “rule rate” changed direction). The FOMC was not comfortable with the “elevated” price of oil and kept hammering on the risks of inflation expectations becoming un-anchored (see the late 2007-08 FOMC transcripts).

Despite the reduction in the FF rate, monetary policy was being tightened! And the “Great Recession” was invited in! Maybe there would have been a “Second Great Depression” if the “policy rate” had been followed closely.

Moral of the story. Yellen and the Fed do not have “infinite degrees of freedom”, hidden under the umbrella of “sound judgment”. They would do well to set a “target rule”.

They think, however, that “committee decision making” is better and more effective. Then, why not have the largest committee possible the market, in addition to the FOMC and its supporting staff, make decisions? That is exactly what is implied by Scott Sumner’s latest version of an NGDP Futures Market, an “instrument” directly linked to the target.


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