Guest Contribution: “Does legislating a rule for the Federal Reserve make sense?”

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.


Carl E. Walsh, “Goals and Rules in Central Bank Design”, International Journal of Central Banking, 11 (supplement 1), Sept. 2015, 295-352.

This post written by Carl E. Walsh.

22 thoughts on “Guest Contribution: “Does legislating a rule for the Federal Reserve make sense?”

  1. JBH

    Debt is the crushing burden compressing potential growth more and more each passing decade. The decadal rate of decline is 4/10ths of a percentage point. This record level of global debt was mostly catalyzed and enabled by none other than the US Federal Reserve. As a consequence of this humongous burden a financial crisis is brewing that probabilistically will put to pale that of the Great Recession. At root, the Fed caused that crisis. The Fed caused all financial crises since its inception. When the latest crisis was ablaze, the Fed came in and doused the fire – the fire it itself had lit! – with unprecedentedly profligate monetary policy. Throughout the economics profession, the unintended consequences have been studiously and quite curiously ignored. Around half of newly created ZIRP and QE liquidity got siphoned off via the US carry trade and shuttled abroad to the periphery. The over-decade-long flow from core to periphery began reversing two years ago. Liquidity is now flowing out of emerging markets in a mad rush, with all kinds of ill consequences there. Historically this kind of large scale liquidity wave and reversal has happened five times before. First in the 1820s when Great Britain was the core and the US the periphery. Each time there were devastating consequences to the core. Panics and lengthy recessions or outright depressions resulted each and every time. Not to mention havoc and devastation in the periphery.

    Moreover, there is a curiously overlooked difference between interest and usury that not one in a thousand is aware of. When money is under the wing and control of the government we have pure interest. Pure interest is a good thing. When the debt and interest are paid down the interest proceeds less operational costs revert to the people in the form of a lower tax bill. Whereas when money is under the control of a private corporation as it is today, usury gets tacked atop the interest. This usury is a steady drain on the livelihood of ordinary citizens since it accrues wholly to the owners of the banks that own the private central bank and to no one else. These owners are, of course, the behind the scenes dictators of monetary policy run to their advantage. They are the butcher with thumb on the scale. Over time, that wealthy elite uses the flow of usury that accrues to them to buy up an ever-growing fraction of the nation’s real physical wealth. Often at rock bottom prices at the trough of a crisis, having first been the strong hands that sold at the top. Look no further for why the Gini ratio has risen since money went fiat in 1971. Fed money creation is both a Ponzi scheme and a skim without end that works its nefarious purpose over long periods of time. Slowly, slowly over decade intervals it squeezes the economic lifeblood out of the working class.

    For those teaching money and banking, fair warning. You no longer have plausible denial. For here is a scholarly reference that will bring you out of the dark: A History of Central Banking and the Enslavement of Mankind, Stephen Mitford Goodson. Goodson is a former director of the South African Reserve Bank.

    Legislating a policy rule for the central bank will accomplish little. At best it will separate responsibility from operational actions. Anyway it is subsidiary to a larger point. Looming over all else – the Fed should be nationalized. This is not going to happen, of course, since as we all know the public is clueless. Instead, at some point the US dollar fiat system will collapse into rubble. All Ponzi schemes finally do. That may be decades away. Or it may be much closer than we think. Already the Fed is between a Scylla and Charybdis. This is evident on many levels, one being that never before in 100 years has the central bank been so quaveringly fearful of making a minuscule quarter point hike.

    1. PeakTrader

      JBH, what you fail to realize is the Fed and the bankers raised living standards for the U.S. masses tremendously.

      You cited 1971 as a turning point. Yet, the Fed prevented a deep depression in the 1970s, then achieved strong disinflationary growth, and then made the current depression less severe.

      You can praise the Fed’s performance later.

      1. JBH

        PeakTrader: Might you be referring to the mid-1970 to mid-1972 period when the Fed deliberately held the real fed funds rate below zero a full two years? Allowing M2 to reach double-digit escape velocity shortly thereafter? Whereby they then immediately slammed on the brakes taking the real funds rate to over 7½%? Which promptly precipitated the ‘74 recession? For which they did a one-eighty and stomped on the accelerator again. This time causing real fed funds to swing an historic 14 percentage points down from 7½% deep into negative territory! And you give them credit for putting out this recessionary fire they and only they created? Astonishing! Which gross policy overreaction, by the way, then precipitated the decade-long marvel known as the Great Stagflation that they and the profession said couldn’t happen. But of course did. Leaving it to Volcker and Reagan to clean up the mess. Which necessitated yet another grave recession. None of which would have had to have been.

        What is it again I fail to realize?

        1. PeakTrader

          JBH, the 1970s was a long-wave bust cycle, similar to the 1930s. When the last of the Baby-Boomers (born between 1946-64) reach 65 in 2029, another long-wave bust cycle will likely take place.

          In the 1970s, the Fed promoted nominal growth, which raised real growth, along with dealing with shocks to the system. The inflationary growth of the 1970s replaced a potential deep depression similar to the 1930s.

      2. Floyd Reese

        JBH believes in the establishment “market” like any good soldier. The long depression and finally the great contraction destroyed the hope of self-regulating markets. The fervent anti-capitalism it created has left scars on markets to this day.

        I will give JBH this, the intellect is stronger than nature.

    2. PeakTrader

      And, you cite the Gini coefficient, since 1971. It should be noted, while there was tremendous upward income mobility in the U.S., particularly by the middle class, since 1971, there was also tremendous immigration from dirt poor countries. So, of course income inequality would increase. However, there’s much less consumption inequality compared to income inequality.

      1. JBH

        PeakTrader: Income inequality is not what it is all about. Wealth inequality is. Vast increases in wealth drive income disparities. This is the perniciousness you evidently do not see.

        Suppose the 1970 wealth distribution had a Gini of .81. Rounding off in your favor, the decadal censuses had foreign born at 5% in 1970 rising to 13% in 2010. Assume all foreign born enter into the bottom wealth decile and spill over into the next higher decile with the same low wealth share as those at the bottom. In fact, put the entire second decile share same as the bottom. All other decile shares unchanged but for an insignificant upward increment, so that the overall conforms to the constraint of total cumulative being 100%. The new Gini is still .81! Immigration has had a trivial to the point of vanishing effect on the distribution of wealth.

        According to Saez Zucman (Wealth Inequality in the United States since 1913, October 2014), from 1970 to 2012 the wealth share of the top decile rose stupendously from 70% to 77.5%. Round that off to 7 percentage points more total wealth share now in the top decile. Holding first and second deciles constant at the original share of the first decile for the immigration effect, then proportionately reduce the 3nd through 9th shares so cumulative adds to 100%, as by definition it must on a Lorenz curve. The Gini is now .92! In other words, immigration had no effect on the Gini. What did have an effect was the vast increase in nominal stock market and other asset wealth. This was due almost wholly to the Federal Reserve ramping up the nominal economy ever since ’71 when dollar went fiat. This is also perfectly congruent with the surge in debt, part and parcel of the larger story.

        You will find precisely the same thing happened to the distribution of income and for the same reason, though not as pronounced.
        There is a dark story here, and few who frequent this website even see it. This ignorance spills over into many other topic areas. When global warming for example comes around, scores of comments here battle back and forth. One side takes the position that the science is settled. Absurd. How can that possibly be so with so many comments back and forth in scholarly journals and all across the internet to the point of ad nauseam and ad infinitum?

        1. PeakTrader

          JBH, a deep depression will reduce wealth inequality. However, it’s much better to maintain sustainable growth (of goods & services), which is optimal growth, even if it means higher asset prices.

          Tens of millions of poor immigrants and their children have high marginal propensities to consume. So, of course, they won’t save much to build wealth. Low interest rates causes dissaving, which raises income = consumption + saving.

    3. PeakTrader

      Rising riches: 1 in 5 in U.S. reaches affluence
      December 6, 2013

      “New research suggests that affluent Americans are more numerous than government data depict, encompassing 21% of working-age adults for at least a year by the time they turn 60. That proportion has more than doubled since 1979.

      Sometimes referred to by marketers as the “mass affluent,” the new rich make up roughly 25 million U.S. households and account for nearly 40% of total U.S. consumer spending.

      In 2012, the top 20% of U.S. households took home a record 51% of the nation’s income. The median income of this group is more than $150,000.”


      Growth in the
      Residential Segregation
      of Families by Income,

      “The proportion of families living in affluent neighborhoods doubled from 7 percent in 1970 to 14 percent in 2007.

      Likewise, the proportion of families in poor neighborhoods doubled from 8 percent to 17 percent over the same period.”

      My comment:

      In 1970, the proportion of Americans in the “affluent” and “upper income” classes, and also in the “low income” and “poor” classes were relatively small, while the proportion of Americans in the “high middle income” and “low middle income” classes were very large.

      If you break down those six classes into three classes, the high and low classes grew and the middle class shrunk. Those three categories are almost equal in size today.

      In 1970, both the high and low classes were about 18% each, while the middle class was over 60%. In 2007, both the high and low classes were about 30% each, while the middle class was over 40%.

      Many middle class Americans moved into the higher classes, while many immigrants from dirt poor countries moved to the U.S. and into the lower classes.

      Despite conventional wisdom, there has been tremendous upward income mobility in the U.S..

    4. artk

      Your “scholarly reference” is anything but scholarly. The author Goodson is “South African banker and politician who is leader of the South Africa’s Abolition of Income Tax and Usury Party. He is best known for statements praising Adolf Hitler and his promotion of Holocaust denial.”

      1. JBH

        artk: You cut and paste your quote directly from Wikipedia. Disparaging the author without speaking to the merits of his book. A book heavily-footnoted with an extensive bibliography. Of solid broad-ranging works like Carroll Quigley’s tour de force, Tragedy and Hope. Books that get to truths that are carefully hidden from the public. When Quigley’s book was first published, there was an attempt to suppress it. This pattern of suppressing anything that conflicts with the mainstream view happens over and over.

        Central banking and usury are tightly intertwined. Readers will learn about this from Goodson. A decade ago, Reinhart and Rogoff enlightened and shocked the mainstream with their historic studies on debt. Thanks to RR, we now know excessive debt is a predictor of the declining rate of real growth. Throughout history, nations whose banking systems were state-owned were more economically successful than others. Ellen Hodgson Brown’s Web of Debt, now in its 5th edition, is another contribution to the important central bank-credit creation-usury nexus that fair-minded inquisitive scholars can and will learn much from.

  2. dilbert dogbert

    Rule based legislation does not go far enough to satisfy the anti-FEDs. They should just go whole hog and abolish the FED. If the FED is handcuffed by rules then does the FED have a purpose?

  3. Tom

    The very first paragraph of this essay is at best a strawman that all of this bill’s opponents continue to spew.

    The FOMC is NOT at all required to use a policy rule, despite your statement that the “FOMC [is] 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.” The FOMC is free to set monetary policy however it wishes, whether that be by following a rule such as Taylor’s or by a purely discretionary procedure.

    The FOMC is simply required to periodically state what the federal funds rate would be if it were to follow a rule and, if the actual rate differs from the prescribed rate, to explain why the FOMC thinks it is necessary to deviate. The FOMC can do whatever it wants.

    Article I, section 8 of the Constitution states that Congress has the duty to regulate the value of the currency. While Congress established the Fed to oversee that task, it is Congress’ responsibility to supervise the Fed; and Congress cannot abrogate that responsibility. If you think Congress should not have such a supervisory role, see Article V.

    1. MacCruiskeen

      And surely no one in their right mind would want Congress debating the details of monetary policy on a routine basis. Yes, Congress needs to retain its authority over the Fed, but not having the Fed would be a disaster.

  4. Jerry McIntyre

    Hi Carl (and Menzie),
    A timely and cautionary post.
    Welcome to the Blogosphere, Carl!
    – Jerry

  5. Ricardo

    Before we consider a methodology shouldn’t we define what we are trying to achieve?

    Menzie (or anyone),

    A serious question – does the FED have any idea what it is trying to achieve? If so what?

    1. rtd

      “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

      1. baffling

        “so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”
        interestingly, for those opposed to the fed, what goals have they not met over the past few years?

        1. rtd

          Although I am not among those you mention, others would argue the Fed has failed to maintain their very own interpretation of stable prices – e.g. “The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate. “

          1. baffling

            one would best categorize the past few years as stable and low inflation. i do not think anybody could really claim inflation has been unstable and high. inflation under 2% should be considered stable inflation, even if your target is higher. as i said, once a person steps away from their ideological perspective, it is a bit hard to argue the fed has not met its goals, at least technically. i think the griping tends to come from a constituency that does not want to work for their money, but prefers passive interest income. over the past few years, that has been a losing proposition at low rates. but i am not so sure the fed’s job is to accommodate that constituency directly.

  6. PeakTrader

    Politicians want to constrain the Fed’s discretion, on monetary policy, although the Fed has become better at smoothing-out business cycles.

    The economy would be much better if politicians give professional economists more power or control over fiscal and other significant economic policies instead.

    1. PeakTrader

      A diverse group of politicians has much less understanding of the benefits and consequences of a particular economic policy, including how that policy would interact in the economy than a diverse group of economists.

      Of course, there would be differences in value judgements. However, I’m sure, the economists would hammer out much better or more appropriate policies.

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