Blogs review: The Taylor Rule legislation debate

What’s at stake: A draft legislation was introduced on July 7 by two Republican members of the House, which would require the Fed to adopt a policy rule. The “Federal Reserve Accountability and Transparency Act of 2014″ (FRAT, HR 5018) was not well received by Federal Reserve’s chairwoman, Janet L. Yellen, who said on Wednesday that it would be a “grave mistake” for Congress to adopt such legislation.

Alan Blinder writes that while the House can't manage to engage on important issues like tax reform, immigration reform and the minimum wage, it's more than willing to propose radical "reform" of one of the few national policies that is working well. As the title of Section 2 puts it, FRAT would impose "Requirements for Policy Rules of the Federal Open Market Committee." In the debate over such rules, two have attracted the most attention. More than 50 years ago, Milton Friedman famously urged the Fed to keep the money supply growing at a constant rate—say, 4% or 5% per year—rather than varying money growth to influence inflation or unemployment. About two decades ago, Stanford economist John Taylor began plumping for a different sort of rule, one which forces monetary policy to respond to changes in the economy—but mechanically, in ways that can be programmed into a computer. 

Nick Rowe writes that we need to distinguish between "instrument rules" and "target rules". The Bank of Canada, for example, sets a nominal interest rate instrument to target 2% inflation. The Bank of Canada follows a very simple target rule: "set (future) inflation at 2%". But it does not follow any instrument rule like the Taylor Rule. Instead it uses its discretion.

Illustration source: Jayachandran/Mint

John Taylor writes in his Testimony to Congress that there is precedent for the type of Congressional oversight in the proposed legislation. Previous legislative language, which appeared in the Federal Reserve Act until it was removed in 2000, required reporting of the ranges of the monetary aggregates. The legislation did not specify exactly what the numerical settings of these ranges should be, but the greater focus on the money and credit ranges were helpful in the disinflation efforts of the 1980s. When the requirements for reporting ranges for the monetary aggregates were removed from the law in 2000, nothing was put in its place.

Tony Yates writes that we should remember that John Taylor sees the performance of the US post-crisis as resulting from the deleterious effects of uncertainty about policy that come with a departure from rules-based policy (for the king of evidence used to make this case, see this post). Nick Rowe writes that it is hardly surprising that structural breaks in an estimated central bank's reaction function should be associated with worse economic outcomes. Suppose a central bank is targeting 2% inflation. Then a big shock hits, that causes a permanent fall in the (unobserved) natural rate of interest. That shock may itself cause worse economic performance. Plus, if the central bank is not immediately aware of that shock, or its magnitude, and fails to adjust its reaction function quickly enough, that will also cause worse economic performance. An econometrician who estimated the central bank's reaction function would notice a structural break in that reaction function, and that structural break being associated with worse economic performance.

The two rules in FRAT

Alex Nikolsko-Rzhevskyy, David Papell and Ruxandra Prodan write that FRAT actually specifies two rules. The “Directive Policy Rule” would be chosen by the Fed, and would describe how the Fed’s policy instrument, such as the federal funds rate, would respond to a change in the intermediate policy inputs. In addition, the report must include a statement as to whether the Directive Policy Rule substantially conforms to the “Reference Policy Rule,” with an explanation or justification if it does not. The Reference Policy Rule is specified as the sum of (a) the rate of inflation over the previous four quarters, (b) one-half of the percentage deviation of real GDP from an estimate of potential GDP, (c) one-half of the difference between the rate of inflation over the previous four quarters and two, and (d) two. This is the Taylor rule, and is obviously not chosen by the Fed.

Alan Blinder writes that while hundreds of "Taylor rules" have been considered over the years, FRAT would inscribe Mr. Taylor's original 1993 version into law as the "Reference Policy Rule." The law would require the Fed to pick a rule, and if their choice differed substantially from the Reference Policy Rule, it would have to explain why. All this would be subject to audit by the Government Accountability Office (GAO), with prompt reporting to Congress. John Taylor writes that to provide some flexibility the legislation allows for the Fed to change the rule or deviate from it if the Fed thought it was necessary.

Gavyn Davies writes that in 2012 Janet Yellen argued that Taylor’s original 1993 Rule was no longer her preferred interpretation of the Rule. She suggested a “balanced approach” alternative, in which the importance given to the unemployment/GDP objective was increased, relative to the importance given to inflation. She also suggested an optimal control approach, under which interest rates would stay even lower than under the balanced approach, because policy needed to compensate for a prolonged period in which the stance had been too tight as a result of the zero lower bound on rates.

Policy rules in extraordinary times

Alan Blinder writes that the deeper problem is that the Fed has not used the fed-funds rate as its principal monetary policy instrument since it hit (almost) zero in December 2008. Instead, its two main policy instruments have been "quantitative easing," which is now ending, and "forward guidance," which means guiding markets by using words to describe future policy intentions. Gavyn Davies writes that the Rule does not say how and when to reduce the size of the Fed’s balance sheet, and how that decision should relate to the appropriate level of short rates. The Rule is also largely silent on another of the Fed’s main headaches right now, which is whether to treat the official unemployment rate as a good indicator of the amount of slack in the labor market.

Simon Wren-Lewis writes that the current natural real rate of interest is likely to be a lot lower than the constant in any Taylor rule. At low levels of inflation, inflation also appears to be less responsive to excess demand. On its own this means that the coefficients on excess inflation in a horse for all courses Taylor rule will be too low when inflation is below 2%.

John Cochrane writes that what is most interesting about a rule is what it leaves out. Notably absent here is "macroprudential" policy, "financial stability" goals, i.e. raising rates to prick perceived asset price "bubbles" and so forth. Of course, the Fed could always add it as a "temporary" need to deviate from the rule. Still, many people might think that should be part of the rule not part of the exception. It also leaves out housing, exchange rates, and all the other things that central banks like to pay attention to.