Demystifying the foggy haze of Federal Reserve policymaking
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During the presidential election, a number of candidates from Marco RubioMarco Antonio RubioCongress faces growing health care crisis in Puerto Rico The Hill's 12:30 Report Colbert mocks Trump for sipping water during speech on Asia trip MORE to Ted CruzRafael (Ted) Edward CruzTexas Republicans slam White House over disaster relief request Dem rep: Trump disaster aid request is 'how you let America down again' Moore endorsements disappear from campaign website MORE endorsed “rule-based monetary policy” as an appropriate way to reform the Federal Reserve. Two of the pending nominees to the Federal Reserve Board have endorsed the same view. Just what is rule-based monetary policy anyway?

While serving as chief economist to the House Financial Services Committee during the 100th anniversary of the Fed, I worked on legislation called the Fed Oversight Reform and Modernization Act, also known as the FORM Act, to implement a rule-based approach to monetary policy inspired by the writings and life work of Stanford Professor John Taylor, a noted macroeconomist and an intellectual heir to Milton Friedman. This legislation passed in the House this year.

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The FORM Act requires the Federal Reserve to show the math it uses to justify its stance on interest rates. In other words, the Federal Reserve must release the policy “rule” it uses to arrive at its interest rate policy. This rule comes in the form of an equation with variables, weighted by coefficients, which produces a target interest rate on the other side of the equal sign.

 

When the rule-based approach gets up and running, markets will no longer hang on every word at the Fed’s announcements. Market participants will instead be able to predict interest rate announcements using current economic data points featured in the policy rule used by the Fed.

The FORM Act would not require the Federal Reserve to select any particular rule. It may select or design any rule it likes, and may change the rule at the next meeting. The Federal Reserve also must describe how the rule it selects differs from the Taylor rule, a guideline popular in macroeconomics circles which the Federal Reserve already tracks internally quite closely.

The Taylor rule uses two simple variables to come up with a suggested path for interest rates. Simply put, it looks to whether inflation is out of control, and it looks to how well economic growth is doing relative to historical trends. When the Fed follows the Taylor rule, it generally does what most people expect our central bank to do. This was the case during the most effective time in Fed history, the Great Moderation of 1987 to 2003.

When Federal Reserve Chair Janet Yellen served as a governor of the Federal Reserve Board during the mid-1990s, she said that following the Taylor rule was “what sensible central banks do.” At the time, the rule suggested a path for interest rate policy that she supported.

Yes, you read that correctly. Chair Yellen was not only a fan of rule-based policy — she was a fan of the Taylor rule in particular. Remember, the FORM Act doesn’t require the Fed use the Taylor rule, but it’s important to note Chair Yellen was previously both a fan of rule-based policy generally and the Taylor rule in particular.

Fast forward 16 years, and Chair Yellen has taken a 180-degree turn on this debate, noting in congressional testimony that a rule-based policy approach would threaten the independence of the Federal Reserve. I suppose your perspective changes when you are handed the reins of power.

The true threat to Fed independence is the foggy haze surrounding Fed policy. Contrary to critics of rule-based policy reforms, a clearer window into the Fed’s decision-making process could preserve Fed independence by shining a light on any political meddling from the executive branch.

Popular views of the Federal Reserve are that of an all-knowing “council of the wise,” a sort of economics cognoscenti that pull levers in the economy using sophisticated equations that the mere layman wouldn’t understand. In reality, a bunch of people sit around a boardroom. They consult sophisticated models, yes, but then they each vote their preferences based on...well who knows what.

After the vote, the Fed’s official stance is then described using words carefully chosen from a thesaurus. Pages of Fed board minutes have been devoted to a discussion of whether to mention that the central bank is following the economy “closely” or instead following the economy “carefully.” That’s no way to run a railroad in a sophisticated modern economy.

Market guessing games may be fun for talking heads on the business lunch programs, and they may make life easier for Fed officials who prefer to avoid accountability for their decisions. Anyone who has taken a math class knows you only get partial credit for the right answer if you fail to show the math you used to arrive there. The same principle holds true in central banks as they communicate monetary policy to the markets.

J.W. Verret is an associate professor at the Antonin Scalia Law School at George Mason University, a senior scholar at the Mercatus Center, and former chief economist for the House Financial Services Committee.


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