Today we are fortunate to have a guest contribution written by Carl E. Walsh, Distinguished Professor of Economics at the University of California, Santa Cruz.
On November 19 of this year, the U.S. House of Representatives passed by a vote of 241-185 H.R. 3189, The Fed Oversight Reform and Modernization (FORM) Act, an act designed, in part, to establish John Taylor’s 1999 rule for the federal funds rate as a “Reference Policy Rule” for monetary policy, with the FOMC required to submit the details of the actual rule the FOMC used to set policy and a statement as to whether this rule “substantially conforms” to the Taylor rule.
Legislating a rule for the Fed’s instrument as a means of constraining its discretion and holding it accountable for its policy actions represents a fundamental shift from a policy such as inflation targeting. Under inflation targeting, the central bank is held accountable for meeting a target that represents an ultimate goal of monetary policy – low inflation – rather than for moving its policy instrument consistent with a specific rule.
The House bill raises important questions: Should central banks be held responsible for achieving specific goals, such as 2% inflation? Or should they be charged to follow specific rules, such as H. R. 3189 proposes? I address this issue in a keynote address delivered at a Reserve Bank of New Zealand and International Journal of Central Banking Conference on “25 Years of Inflation Targeting”, held a year ago to mark 25 years since the passage of the Reserve Bank of New Zealand Act of 1989. In Goals and Rules in Central Bank Design,” IJCB (2015) [Ungated WP version], I use a simple theoretical model to show that both a goal-based system based on an inflation target and a rule-based system based on the Taylor rule balance a tradeoff between reducing sources of policy distortions and preserving policy flexibility. Using an estimated DSGE model, I find that the optimal weights to place on goal-based inflation and rule-based Taylor rule performance measures depend importantly on the output measure employed in the rule. When the rule is similar to that proposed recently in U.S. H.R. 3189, I find the optimal weight to assign to the rule-based performance measure is always equal to zero – that is, the rule H.R. 3189 proposed would lead to inferior macroeconomic outcomes and should not be used.
This result is largely driven by the fact that the definition of output used in the legislated rule – output relative to trend – is not consistent with the definition of output the theory behind the model I use would imply – output relative to its efficient level. When the Taylor rule is modified to use the measure of economic activity that is more consistent with basic macro theory, outcomes can be improved by making deviations from such the rule a part of a system for accessing the Fed’s performance and promoting its accountability. However, this suggests that a legislated rule would need to be very carefully designed if it is to lead to improved policy outcomes, and the performance of any specific rule may depend critically on model used to assess it.
This post written by Carl E. Walsh.