I had the privilege of attending a conference in St. Louis this week on Monetary Policy under Uncertainty at which I presented a paper on the response of interest rates to changes in the fed funds target. One of the interesting themes that came up in some of the other papers concerned whether the public’s interests are best served when monetary policy follows mechanical rules as opposed to responding to events in a discretionary way. Here I report on some of the discussion of this issue from the conference.
Federal Reserve Bank of Philadelphia President Charles Plosser suggested that simple rules, such as Stanford Professor John Taylor’s suggestion that the Fed should mechanically raise its interest rate target when either inflation or output were above the long-run objectives, had much to recommend them, as mechanisms that proscribe the actions of the Federal Reserve, could help frame the FOMC’s discussion of the various policy options, and provide a common ground for discussion among people with different models and understandings of how the economy works.
Federal Reserve Chair Ben Bernanke, who participated from Washington via video conferencing, offered a more qualified endorsement of that thesis:
A promising alternative approach … focuses on simple policy rules, such as the one proposed by John Taylor, and compares the performance of alternative rules across a range of possible models and sets of parameter values (Levin, Wieland, and Williams, 1999 and 2003). That approach is motivated by the notion that the perfect should not be the enemy of the good; rather than trying to find policies that are optimal in the context of specific models, the central bank may be better served by adopting simple and predictable policies that produce reasonably good results in a variety of circumstances.
Perhaps not surprisingly, John Taylor also argued that there are strong benefits when the actions of the central bank are easily understood and predictable by the private sector.
There was also a very interesting paper on this topic by Central Bank of Cyprus Governor Athanasios Orphanides and Goethe University Professor Volker Wieland (both former staff economists of the U.S. Federal Reserve Board). Their paper explored what happens when we try to explain the fed funds rate not from the actual values of inflation and GDP, as in Taylor’s original formulation, but instead with the forecasts of inflation and GDP that the Fed provides through its semiannual Humphrey-Hawkins report. Brandeis Professor Stephen Cecchetti, former Director of Research at the Federal Reserve Bank of New York and Associate Economist of the Federal Open Market Committee, protested that these forecasts were sometimes produced in a somewhat ad hoc fashion. But Orphanides and Wieland noted that the fit of a Taylor Rule to the data improved substantially when forecasts were used in place of actual outcomes as explanatory values in the regression, with the Rbar squared increasing from 0.74 to 0.91. In particular, the forecasts explain why the Fed chose to cut interest rates a little sooner in the early phases of the recessions of 1990 and 2001, as the Fed (correctly) anticipated the downturn. On the other hand, an error in predicting the resurgence of inflation in 2003-2004 may explain some of the slowness of the Fed to raise interest rates, on which we’ve commented previously.
One curious aspect of the success of Orphanides and Wieland’s calculations is the fact that the basis on which the Fed reported its forecasts changed significantly over this period. The Humphrey-Hawkins inflation forecast started out as a prediction for the CPI, was converted to a prediction of the personal consumption expenditure deflator in 2000, and then changed to a prediction of the core PCE inflation in 2004. The surprising thing the researchers found is that the Fed seemed to treat these three forecasts as essentially the same number, even though the three series in fact behaved very differently. This seems like the kind of thing that could provide more ammunition to cynics of the core PCE concept.
This observation also raises a practical objection to the claims for “discipline” of a policy rule, which Chair Bernanke articulated in some of the floor discussion. This is the fact that, although a mechanical rule might appear to constrain Fed actions, in practice there are very relevant issues as to how one measures “potential GDP” or even inflation itself, which allow even a policymaker notionally constrained by a rule a fair bit of practical wiggle room, putting us back into dependence on the wisdom of the discretionary actions of the Fed, for better or worse. On this point, I thought that some of the closing remarks from retiring Federal Reserve Bank of St. Louis President William Poole were rather sage. Poole opined that the best way for the central bank to achieve credibility is to (1) say what you’re going to do, and then (2) do it. He noted the tremendous pressures in a place like Washington D.C. to bend the rules, the natural cynicism with which the public greets pronouncements from the government, and the way that a lack of credibility greatly complicates the ability of the central bank to do its job. He concluded that, above all, a central bank needs to be run by people of unquestionable integrity who can steer a clear course through such pressures.
Amen to that, Bill. And would that it could be the same for Congress and the White House.