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 ¬Ω 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 ¬º 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.