Mechanically following the Taylor rule would limit the central bank’s policy tools and harm the economy.
By Neel Kashkari
The Wall Street Journal
December 19, 2016
After extraordinary actions by the Federal Reserve during and following the Great Recession, including quantitative easing programs and record low interest rates, some economists are calling for the Federal Open Market Committee to mechanically follow a simple rule in conducting monetary policy. As a regional Fed bank president and member of the FOMC, I believe this would unduly limit the Fed’s policy tools and ultimately harm the economy and in turn employment.
The idea is to effectively turn monetary policy over to a computer, rather than continue to let Fed policy makers use their best judgment to consider a wide range of data and economic trends. The classic example of such a rule is the one proposed by Stanford economist John Taylor more than 20 years ago. The “Taylor rule,” as it’s widely known, calculates a desired level for the federal-funds rate based on measures of inflation and economic output.
My staff at the Minneapolis Fed has estimated that if the FOMC had followed the Taylor rule over the past five years, 2.5 million more Americans would be out of work today. How many people is that? It’s enough to fill all 31 NFL stadiums at the same time, almost 6,000 more people out of work in every congressional district.
Why would the Taylor rule have caused so much harm to so many Americans? Because the rule would have called for much higher interest rates during this period than was appropriate. For example, last week the FOMC raised the federal-funds rate by a quarter percentage point to between 0.50% and 0.75%. The Taylor rule would call for an increase to 3%.
As part of its process to determine appropriate monetary policy, the FOMC consults rules such as the Taylor rule to see what they recommend. But ultimately we use judgment and historical precedence to decide if that guidance makes sense given other important economic trends that rules don’t consider.
Advocates of rigid rules-based monetary policy are pursuing laudable goals that I share. In theory, stringently following simple rules has the potential to reduce policy uncertainty and unnecessary market volatility, increase the Federal Reserve’s credibility in pursuing its dual mandate and reduce potential vulnerability to political pressure.
But to gain these benefits, the FOMC would need to specify the rule and then—this is the most important part—stick to it, regardless of economic conditions. If the FOMC were to make exceptions, even rarely and with good intentions, most of the benefits of mechanically following a rule would be lost. Uncertainty and volatility would return as soon as discretion re-entered the equation. Unfortunately, sticking to such a rule no matter how the economy evolves can be very damaging.
Over time researchers have made various adjustments to try to improve the original Taylor rule to make up for its shortcomings. But the global and U.S. economies are complex and continuously evolving. Over the past 25 years the world has seen extraordinary technological innovations, the rise of China, the creation and strains of the eurozone, the financial crisis and U.S. inflation falling from around 4% to less than 2%. No simple algebraic formula can take into account such a dynamic global economy. Google Maps is a brilliant application. Every once in a while it recommends driving into the middle of a lake.
Some advocates argue that there would have been no housing bubble if the FOMC had followed the Taylor rule. This assertion is demonstrated to be false by the fact that many advanced economies, such as Britain, Spain and Australia, also experienced housing bubbles at the same time the U.S. did, even though they each had their own monetary policies in their own currencies. U.S. monetary policy can’t explain a housing bubble in the U.K.
Rather than trying to reduce uncertainty by forcing the Federal Reserve to mechanically follow a rule, we need to make monetary policy a lot less important to the trajectory of the economy. We need an economy that is growing strongly on its own, driven by real, productivity-enhancing investments, rather than support of the central bank. Markets are signaling optimism that the new Congress and the incoming Trump administration might enact fiscal and regulatory policies that could drive that type of real economic growth.
If markets are right and that growth materializes, the last thing we will want is monetary policy on autopilot that could quash the recovery because it is unable to recognize if productivity and potential output are rising and the economy has room to run. A high-growth, investment-driven economy will automatically put monetary policy on the back burner, where it should be.
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