There are good reasons for monetary rules

There are two ways to conduct monetary policy. One approach is to give monetary policy makers the power to decide their policy whenever they see fit. Another approach is to force them to abide by and follow the monetary rule that dictates how monetary policy will unfold. The Fed’s lukewarm response to high inflation over the past year suggests that a monetary rule would be better.

Cautionists say it is unwise to tie the hands of central banks with a monetary rule. The monetary rule cannot be changed to account for unforeseen circumstances. They argue that prudence gives the central bank the flexibility to do what it needs to do in a crisis.

Supporters of monetary rules acknowledge that a rule can prevent a central bank from doing what it should do in some emergency. But, unlike discretion, the rule demand the central bank to do what it must do in all other cases. Therefore, the performance of a rule with respect to a discretionary central bank depends largely on the extent to which the rule can determine in advance the optimal monetary policy and on the likelihood that the central bank will do what it is supposed to do if it is not required to do so. . by the rule.

Discretionary advocates often ignore the trade-off between rule and discretion, assuming that monetary policy makers will respond appropriately as events unfold. However, the Fed’s response over the past year is highly questionable. Instead of evolving according to the available data, as Chairman Powell often said, the Fed will act slowly, the Fed has been slow to react.

By October 2021, it was clear that production was quickly recovering from cuts due to COVID-19. But prices did not return to the trend. They kept growing! Yet Chairman Powell and other members of the Federal Open Market Committee (FOMC) continued to insist that inflation was transitory until the end of November. After all, in December 2021, the FOMC acknowledged that inflation was at least partly driven by demand. But he did not take immediate action. Instead, he set the course for a small rate hike in March 2022.

Once the Fed had this plan, it clung to it for far too long. Month after month, the data showed that inflation was even worse than expected. But the Fed did not revise its plan. The Fed did not take major action until May 2022, when it raised its target federal funds rate by 50 basis points. And he didn’t break the plan he outlined in December 2021 until June 2022, when he surprised the markets with a 75 basis point rate hike. For almost half a year, the Fed did not respond to the incoming data. He just blindly stuck to the course.

The discretionary nature of the Fed makes it harder for businesses to plan, making it unclear how the Fed will react to new data. In accordance with the monetary rule, enterprises must forecast the demand for their products and the supply of their resources. With caution, they should also predict what the central bank will do if it is not specified in advance in the rule. Even if the rule may not be fully enforced, it may nonetheless provide an indication of how monetary policy will unfold. given the unexpected departure from the rule. With caution, there are no such guarantees.

Discretionary monetary policy is also much more dependent on individual personnel. The composition of the FOMC may suddenly change due to regular rotation (in the case of Regional Presidents of the Reserve Bank) or new appointments. The latter makes it particularly difficult to predict how monetary policy will be conducted. It’s hard to tell how FOMC members are likely to vote at some upcoming meeting if you don’t already know who they are. Consider, for example, that the Federal Open Market Committee began the year with three vacancies. Philip Jefferson and Lisa Cook were added in May. Michael Barr was added in July. Prior to their respective confirmations, anyone who tried to predict monetary policy did not even know whether Jefferson, Cook or Barr would help make important monetary policy decisions, not to mention how they will make those decisions.

Some will be tempted to dismiss these staffing issues as non-essential. But they were of great importance in the past. When Benjamin Strong fell ill in late 1927, he lost influence and was eventually replaced by George L. Harrison. Some have suggested that the Great Depression could have been avoided if not for Strong’s untimely death.

Monetary rule is not a panacea. But a good rule can trump discretionary monetary policy. A good monetary rule does more than predetermine the appropriate course of action. It also requires monetary policy makers to follow this course and thereby reduce the uncertainty faced by businesses and consumers.

Nicholas Kachanosky

Nicolas Kachanosky

Nicholas Kachanoski is Associate Professor of Economics at Denver Metropolitan State University. With research interests in monetary and macroeconomics, much of his recent work has focused on incorporating financial duration into traditional business cycle models. He has published articles in academic journals, including the Quarterly Review of Economics and Finance, the Review of Financial Economics, and the Journal of Institutional Economics. He is co-editor of the magazine Libertas: Segunda Época. His popular works have been published in La Nación (Argentina), Infobae (Argentina) and Altavoz (Peru).

Kachanoski received his MA and Ph.D. He received a bachelor’s degree in economics from Suffolk University, an master’s degree in economics and political science from the Graduate School of Economics and Government of Empires, and a graduate degree in economics from the Pontifical Catholic University of Argentina.

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