Rules vs. Authority in Central Bank (and Other) Policies-Becker

There is tremendous speculation about how much, if at all, the Fed will reduce the federal funds rate at its meeting next week on Sept. 18th. This is the interest rate that banks use to lend their reserves held with the Fed to other banks. This rate in turn affects the interest rates banks charge borrowers, and ultimately that affects other interest rates in the economy. The Fed changes the federal funds interest rate through open market operations that involves buying or selling bonds. Some investors are looking for a full ½ point reduction from a federal funds rate of 5 1/4 per cent to 4 3/4 per cent, while others expect a reduction of only ¼ of one per cent. If the Fed took no action, there would be many disappointed investors, and probably a large sell off in worldwide stock markets. The uncertainty among investors about what the Fed (and other central banks) will do, and the expectations that form around this uncertainty, have created an environment where central banks almost have to take some actions to avoid major negative reactions in financial markets. Instead of central banks determining expectations in financial and other markets, expectations are now determining central bank policies. As decision time approaches, the Fed comes under enormous political pressure to take the actions expected by influential investors and businesses. Although political and other forces help determine what the Fed will do, there is still great uncertainty over the precise actions it takes, as with the current speculations over the magnitude of the change next week in the federal funds rate. This political process surely is not what was intended when "independent" central banks were created. To regain control over expectations and its own policies, the Fed should establish a rule easily calculated from publicly available information about how the federal funds rate is determined. With such a rule, investors and businesses would be able to forecast perfectly what the Fed will do next week because market participants would know all the information that determine the Fed's behavior. There could be no disappointments, and all market adjustments to any changes in the federal funds rate would be fully and continually incorporated in asset prices and other market measures before, not after, the Fed makes its decisions. Then Fed policies would be determining expectations about interest rates and other variables rather than the other way around. To show how rules would work, suppose the rule was to target the inflation rate at 2 per cent per year. If say the actual inflation rate were 3 per cent over a several month period prior to a Fed meeting, the Fed would "lean against the wind", and raise the federal funds rate from its long run level by a specified amount known in advance to investors. This would counteract the higher than desired inflation rate. Conversely, if the actual inflation rate had been 1 per cent, the Fed would lower this interest rate by a specified amount that would be known by market participants. This action would help strengthen an economy that was weaker than the Fed desired. Investors would know what the Fed would do weeks and even months before the Fed did it, and they would adjust their behavior more smoothly to their accurate expectations about central bank behavior. The same considerations would apply to more complicated "Taylor rules" that relate actions by the Fed not only to deviations of actual inflation rates from a targeted rate, but also to deviations of actual GDP growth from a potential growth rate. Since information could be made available to the public about how the Fed would use trends in labor force growth, investments, and productivity to calculate potential GDP growth, the Fed's responses implied by such a rule would also be known in advance. In this way, investors and other market participants could anchor their expectations to what the Fed will actually do in different macroeconomic situations. According to a recent unpublished paper by John Taylor of Stanford University, the Fed would have raised the federal funds rate between 2002 and 2006 by considerably more than it did had such a Taylor rule been followed. By doing that, the Fed's actions would have prevented some of the mortgage and other lending at very low interest rates that took place during the past few years. Taylor's analysis suggests that following such a rule would have reduced, and perhaps even largely eliminated, the excesses in the housing boom since 2003. Although the Fed is the most influential central bank, similar advantages of rules over discretion in setting interest rates apply to the European, British, Chinese, Japanese, Indian, and other major central banks. The less important central banks already have little discretion over their interest rates since global forces outside their control basically determine these. Of course, in the global economy what any major central bank does, especially what the Fed does, greatly affects the choices available to other central banks. The use of rules rather than discretion to guide interest rate policy would shield central banks from domestic political pressures, and would anchor market expectations in accurate knowledge about what central banks will do in various local and global economic circumstances. These types of advantages of rules over discretion apply not only to central bank behavior, but also to policies by other government agencies. For example, should anti-trust authorities treat each merger, buyout, or meeting among competitors as unique events that require separate analysis to determine if they are anti-competitive, or should these regulators have clear and easily understand rules about what determines anti-trust violations? Clear rules are preferable here too since that would enable companies to predict the responses by anti-trust regulators when considering mergers and other actions. It would also help insulate these regulators from political pressures. In particular, the American and European attacks on Microsoft, and the European opposition to the merger of GE and Honeywell, probably would not have happened if competitive policies were guided by clear and sensible rules about what constitutes anti-competitive actions rather than by complaints of and pressures from politicians and from competitors to Microsoft and GE.

Comments

[Stéphane]

Automatic rules and fixed targets would remove a lot of the Fed's discretionary power and importance, and might reduce political influence on its operations.

On the other hand, I wonder if such a rigid institutional setting would be compatible with the price-adjusting mechanisms of a living economy. For instance, a stringent stabilization of consumer prices could result in an increased volatility in asset prices. What can we learn on this issue from other existing central banks?

This also brings up some free banking arguments that a money-creating monopoly does not have the right incentives to adjust the characteristics of its product to the needs of its customers. And even under the assumption that the monopoly intends to provide a good product, the absence of competition and price signals makes it difficult to make the right decisions.

[应品广]

Now we can say that the imperialism of economics actually exists. It seems that all the decisions being made can be through rules constituted by economic ways. The only thing we need to do is just calculate the numbers and figures and see if it deviates the one we have calculated. But the real world is much more complicated!
As in the antitrust field, it's hard to say if cartels or mergers impedes the economic efficiency by mere "economic rules", instead it's influenced by many factors which need to be considered by not only economists but also others including judges.

[Skav]

The lack of perspective in this article is disappointing. There has been a wide literature about monetary policy objectives, especially inflation targeting, and the conclusions are much more balanced that "it would be better". Especially, automatic rules can be very poor in certain circumstances, and are much more easily abused. Anti-trust laws appear extremely abusable in this matter.

A synthesis :
http://www.bank-banque-canada.ca/en/conference/2005/mishkin.pdf

A broader view :
The Inflation-Targeting Debate
Ben S. Bernanke and Michael Woodford, editors
The University of Chicago Press, 2005

[Nic D]

Interesting; I had only ever heard inflation targeting mentioned before as a transparency reform, not as a political independence reform. This post seems to combine the ideas. Even if such a rule were instituted, however, the level of uncertainty that surrounds monetary policy would leave the central bank exposed to political pressure, just on a different level -- a war between those who would like to see inflation brought to heel very quickly vs. those who would like to see it gradually suppressed. No? After all, the art of monetary policy comes not in seeing what has happened (that's the data agencies' job), but guessing the direction and acceleration of future changes contingent on different actions and shocks. I'm not sure, in the presence of uncertainty, there is a large practical difference between Becker's rule and Posner's standard.

[Francisco]

I completely agree on that adhering to a rule would stop the Fed from accomodating to the market's expectations.
Research has shown, however, that the effect of monetary policy on the real economy depends on the "suprise factor" of the Fed's actions. Anticipated interest rate changes have smaller effects than unanticipated rate changes.
Strict adherence to a Taylor rule would eliminate all surprise from the Fed's actions, and therefore reduce the Fed's power to "finetune" the economy.

I believe, though, that the Fed should commit exclusively to fighting inflation, and stop caring about growth, especially given the current levels of household debt and lack of mutual trust in the inter-bank lending market (see my blog post on 9/14/2007 at www.econweekly.com). But even if the Fed were to eliminate growth from its objective function, it would be under pressure to cut interest rates after news of economics slowdown. One solution to make that commitment credible would be adopting a rule, as Becker proposes, and one that included only inflation. Another one would be a mandate from Congress.

[Jack]

Ha-Ha! Surely if the Fed "snoozed" or worse? failed to act (for some reason???? think of any?? ) after Gspan "belatedly" "discovered" the mortgage mess a couple years ago, we'd better let them have the authority to try to fix up their mess. I mean "gimme a break!" these ARE out top bankers, armed with massive computing power and the decade long "S&L crisis" is still in the rear view mirror. As crude as it seems, surely it's better slap a patch on it than stand on "Hooverian principle" and risk taking down the world economy, again.

Secondly, IF anyone favors putting the central bank on auto-pilot we'd better pre-define our terms and program in wise responses. For example "inflation" typically means that demand outstrips supply and creates an upward wage/price spiral that feeds on itself. As clumsy a mechanism as it is in a "global economy" the Fed is best at "cooling" such an economy.

Today we should note that we are not in a market that is taxing our production capacity, nor a short labor supply; wages for working folk have been flat for decades. Thus, there should be NO demand pull "inflation" at all. It's hard to know our "capacity" when mfg is a small percentage of the GDP and to some extent, capacity is nearly infinite due to the ability to outsource mfg and even design or engineering projects, but I see figures of us running at 70% of capacity, and that was before housing tanked.

The other type of inflation, of course, is "cost push" and that is the main cause of our price increases today. Trouble is the prices are set by "factors" beyond our control, or so the game is played.

Thus whatever "cooling" effect might be hoped for in the demand pull situation is hardly the cure for cost push as costs and prices are due to external factors that will not be changed much by raising interest rates. In fact, as alternative energy projects, such as wind, or the very long process of building nuclear facilities are thin margin deals with a long pay-back, they are very sensitive to interest rates; tightening money may be counter-productive.

As for "political pressure" perhaps more is better? For example the rapid escalation of energy prices is deflationary as the dollars taken by energy costs can not be used to chase other goods, including those in which energy costs are a major component.

Then, over on the "political side" a decision has been in place for 6 years to "spur" the economy via a tax break and the attendant deficit spending, though "spurring" by putting the fruits of the deficit spending in the hands of those of least propensity to spend is hardly the classical model.

There is one last time of "inflation" or apparent inflation which is the decline in value of the script used to pay the price. Since nearly every product we consume today has a foreign component in its make up, as our dollar declines the prices of even our "domestic" goods appears to rise. What are the classical roots of the decline in purchasing power of our dollar? The "biggie" would be that of selling less abroad than we import and at the current rate is sure to exceed $700 billion this year or about 5% of our GDP.

The second is our federal debt which is now 65% of GDP (up 28% in six years) w/o counting predicted shortfalls of Medicare and other demands on the public purse.

All in all it's quite a hairball and well beyond the clumsy tools open to Bernanke or an auto-pilot and instead is a message that our democracy is not working very well at all.

It's not difficult for the pols to understand that a "war time footing" with large deficits will be inflationary and were there political will one means of dampening it would have been that of a stiff tax on oil and NG to both lower our, one billion per day imports, and to pay for "the war". It would also serve to give notice to those profiteering by selling energy at five and ten times the cost of production that their best customer was not going to stand still for it.

Bust the cartel pricing of oil and tighten up mortgage lending and Voila! "inflation" disappears.

Next? Not a peep on the political stage about our massive trade deficits; not the admin nor any of the dozen or so candidates. But a CEO with a trendline like that of our trade deficit would surely be bounced in short order if he was not addressing it and proposing some means of lessening it or reversing the trend. Health care reform is certainly a part of the problem, but a truly American solution would be that of finding out why we are no longer competitive and addressing the problem before there are no options left.

So......... no a computer can't fix the messes made by man. But perhaps we should talk about a commission with overlapping 6 year terms that coordinates tax policy with central banking policy with a goal of more economic stability and with enough power to say to the President and Congress "Oh, so a war is brewing? Ok, we'll have to raise the money for it, would you rather add to the income tax or put on energy this time?" Jack

[Pete Prokopowicz]

1) Wouldn't the Fed be able to adjust its inflation target instead of interest rate target, creating just as many surprises as we have now?

2) In the 70's, it seemed that OPEC had a lot to do with rising prices throughout the economy. Then, in the 90's, technology was credited with contributing to very low inflation. How do we know that the Fed's interest rate can overcome these kinds of effects and produce any desired rate of inflation?

[Jack]

Whew! It's dead here! Does that mean everyone is cool with the one foot on the brake, one foot on the gas result of the Fed and the deficit spending by the Federal government?

[firma]

ich würde mich freuen wenn du dich in meine Freundesliste einträgst.

[Laurence Weiss]

Dear Gary:

Having just read your posting of September 16 I am somehat disappointed to see that you have slipped into the Samuelsonian position of making macroeconimic policy prescriptions while ignoring economics. Excuse me but what externality are we correcting when we "lean agains the wind"?

Personally, I believe your policy prescription would lead to explosive inflation (or deflation) as the fed would "ratify" any exogonous shocks. But since nobody can agree on a model there doesnt seem to be a way to decide.

[Raul]

Why not decommission the Fed out entirely!A true monetarist approach. Its the Fed that creates this circus with a Las Vegas feel to it and everyone betting on what Bernake et al will do!!

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