Monetary Rule for Better Policy

US monetary policy, well formulated, can enhance overall economic health and contribute to greater market stability. The current system does not measure up to that ideal. This issue of SriKonomics discusses a step that could move the needle toward greater efficiency. It is a step that would be sufficiently flexible to adjust to economic circumstances, yet not allow excessive human discretion to affect the economy or markets.

At present, the policy is formulated and administered by the 12 members of the Federal Open Markets Committee — seven members of the Board of Governors and the President of the Federal Reserve Bank of New York, who are permanent members; and four of the regional bank Presidents who serve one-year terms on a rotating basis. While the members vote at their meetings to maintain, or to change, interest rates and other measures, they act with no strict guidelines on how they should administer policy.

The problems are at least two-fold. First, despite steady warning signs that inflation was likely to be sustained (as I discussed here and here), Federal Reserve Chairman Jerome Powell continued to insist that it was “transitory,” giving him the policy green light to continue with near-zero Federal Funds rate and a steady expansion of the central bank’s balance sheet.

Once Powell realized that he had made a serious mistake with his inflation forecast, rather than admit the seriousness of the error and its implications for the economy, he took credit at the House Financial Services Committee hearings on Wednesday for having “pivoted pretty quickly.” Talk about trying to snatch victory from the jaws of defeat!

The second problem with employing discretionary policy is the existence of what Milton Friedman called “long and variable lags” in the impact of monetary policy on the economy. In “A Monetary History of he United States, 1867 - 1960” that he co-authored with Anna Jacobson Schwartz, the authors studied 18 different economic cycles over a century of economic history to come to their conclusion. Friedman reasoned that an anti-inflationary policy may not have its impact until several quarters later when the economy may already have entered a recession.

The Friedman / Schwartz empirical study results go against the argument that Powell has made repeatedly that he and his Fed colleagues have the necessary tools to change policy once they decide that a different set of instruments, e.g., higher interest rates, is necessary. As I noted last week, the upcoming Powell policy switch expected March 16 may push the economy into stagflation rather than painlessly end inflation.

The unpredictability of the timing and impact of monetary policy is a major reason why rules-based set of measures are necessary to replace the existing ones. In a paper he published in 1993, Stanford University Professor John Taylor devised a rule that would vary depending on economic conditions, giving it sufficient flexibility.

Specifically, Taylor Rule would have the interest rate be based on how distant the economy is from its potential rate of growth, and how far away the implicit GDP price deflator is to the monetary officials’ target inflation rate. If real GDP rises to above the economy’s potential, or if the inflation exceeds the central bank’s target rate, the Taylor-devised formula would automatically move up the Federal Funds rate by a known magnitude.

The attractiveness of Taylor’s approach is that it is not static. It has the ability to respond to different economic conditions as signaled by inflation and economic growth.  Yet, the rule would prevent monetary officials from exercising total discretion to set interest rates just because they think inflation is “transitory.” If the Federal Funds rate had been increased steadily over the past year in response to the US economy’s recovery from covid and the pickup in inflation, we would not be in the position today of requiring several rate hikes that may end the recovery.

In a speech she gave at the National Association of Business Economists in March 1996, Janet Yellen, then a member of the Board of Governors of the Federal Reserve, endorsed the Taylor proposal saying that it had “several desirable features.” She subsequently became the Chair of the Federal Reserve in 2014 for a four-year term but discretionary monetary policy continued during her leadership as well.

Jerome Powell, her successor, carried discretionary policy to new extremes. He more than doubled the Fed’s already bloated balance sheet between February 2020 and February 2022, and has kept the Federal Funds rate at close to zero during the past two years even though inflation is running at 40-year highs.

Despite the positive reception that the Taylor Rule got from the Fed in the 1990s, a rules-based policy remains a dream a quarter century later. Both for investors and for wage earners, the need for such a policy will likely become more urgent over the next several months.

Dr. Komal Sri-Kumar

President

Sri-Kumar Global Strategies, Inc.

Santa Monica, California

srikumar@srikumarglobal.com

@SriKGlobal

March 5, 2022

Sri-Kumar Global Strategies, Inc. advises multinational investors and sovereign wealth funds on global risk and opportunities.  Dr. Sri-Kumar is regularly featured on business TV and Radio media, and is a frequent speaker in global financial centers on major topics that affect markets and investments.

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