The Federal Reserve’s new chairman, Kevin Warsh, plans to convene no fewer than five task forces to review the central bank’s methods and operations. They will ask how the Fed can improve its communications, balance-sheet policy, use of data, understanding of “productivity and jobs in an era of transformation,” and delivery of price stability.
The ambition is admirable, and he is right that all these questions are consequential and worthy of a fresh look. Yet it doesn’t help to split the terrain into so many parcels. Everything comes down to that last item: price stability, which is — or ought to be — the Fed’s overriding purpose. The other questions are subsidiary, and what’s more they overlap, so they can’t be answered independently. It would be a shame if the best and simplest change Warsh could make gets lost in a huddle of task forces.
That long-overdue reform would be to rely more on rules to direct monetary policy — an idea that Warsh has frowned on in the past, without ever clearly saying why.
A monetary rule says how policy should change in response to new information. The Taylor rule is the archetype. It ties the policy interest rate to three components: the so-called neutral interest rate (one that maintains with price stability and maximum employment in the long run); deviations of inflation from the Fed’s target; and deviations of unemployment from maximum employment. If inflation is running above target and the economy is at full employment, for example, the response is to raise the policy rate.
Well, things are rarely so simple. The Taylor rule has many versions, depending on exactly how the variables are defined and measured, how they’re weighted in the formula, how abruptly it tells policy to shift, and so forth.
All of which raises a question: If no single version is unambiguously correct, how does the rule help? Also, central banks surely have to weigh a vast amount of other, frequently conflicting information in judging policy. Maybe the neutral rate is changing for some reason. Are prices distorted by (cough) transitory forces? Is something strange going on in the labor market, affecting the estimate of maximum employment?
These are good reasons not to use any kind of Taylor rule to dictate policy. But that isn’t how such rules should be used. The point, instead, is to use a rule to organize and discipline the Fed’s judgments and help it explain its actions to the public. The rules provide a presumption — weak or strong, according to taste — about changes to the policy rate, and call for an explanation if the Fed decides to do something else.
Up to a point, Taylor-rule calculations already guide the Fed. According to one interpretation, in fact, their best use is to explain why the Fed acted as it did, not what it ought to do in future. In any event, the Fed’s policymakers are aware of what Taylor-type rules are advising, even if they prefer not to dwell on it.
Loretta Mester, former head of the Cleveland Fed, noted at a recent symposium that the Fed’s semiannual Monetary Policy Report to Congress discusses Taylor-rule prescriptions drawn from several versions. The material isn’t exactly front and center — it’s first mentioned on page 43 — but it’s there. (Recent editions make it plain, by the way, that the Fed had a lot of explaining to do from mid-2021, when it held the policy rate at zero for months too long after the rules began saying an increase was needed.) “It would not be a large leap,” Mester said, to start using these prescriptions “as a reference point in policy communications.”
Agreed. That would be a small step and a big improvement. Even better would be to make a forecast of nominal GDP the focus of attention.
The Fed’s policy instruments — including balance-sheet operations as well as the policy rate — don’t operate directly on inflation or unemployment; in the first instance, they drive demand, measured by nominal GDP. If the Fed expects the economy to grow at 2% a year over the longer term and its inflation target is 2%, then trend growth in nominal GDP should be 4% a year. If the Fed expects demand to grow faster than that, its presumption should be that tighter policy is indicated; and if, perhaps for good reason, it chooses not to act, it ought to say why. This approach is Taylor-like in spirit but easier to explain, more forward-looking (because it’s based on a forecast), and recognizes with all due modesty that monetary policy is a blunt instrument that can’t act separately on prices and jobs.
In a recent column, my Bloomberg Opinion colleague Bill Dudley argued that if Warsh’s Fed adopts meeting-by-meeting discretion and obfuscation as operating principles, it will make financial markets more volatile and undermine its credibility and hence effectiveness. The Fed, he said, needs to tell investors more about its “reaction function.” That’s undoubtedly right. But before telling investors more about it, the Fed needs to choose one. That’s exactly what Taylor-type rules, and ideally a nominal-GDP rule, would deliver. I commend the idea to all five task forces.
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