First Principles by John B. Taylor

Author:John B. Taylor
Language: eng
Format: epub
Publisher: W. W. Norton & Company
Published: 2011-12-18T16:00:00+00:00

Writing a Policy Rule into Law

When I proposed a simple policy rule as a guide for monetary policy twenty years ago, I made no suggestion then that the rule should be written into law, or even that it be used to monitor policy, or hold central banks accountable for their actions. The objective was to help central bankers make their interest rate decisions in a more rule-like manner and thereby achieve the goal of price stability within a framework of economic stability. The rule incorporated what we knew at the time from research on the optimal design of monetary rules. In the years since then we have learned much more. We learned that simple rules are robust enough to accommodate widely different views about how monetary policy works. We learned that such rules are frequently used by financial-market analysts looking at monetary policy and by policymakers in their own deliberations. We learned that when policy hews close to such rules, inflation is low, expansions are long, unemployment is low, and recessions are short, shallow, and infrequent; but when policy deviates from such rules, economic performance is poor, with more recessions, higher unemployment, and higher inflation.

This experience has led some monetary scholars and historians—such as the monetary historian Allan Meltzer—to propose that the Federal Reserve be instructed to follow such a rule. A legislated rule could reverse the short-term focus of policy and restore credibility in sound monetary principles.

To see how we might legislate monetary rules, it is useful to look back to the history of legislation relating to the growth in the supply of money, or as different measures of the money supply are sometimes called, “the monetary aggregates.” Until the year 2000 the Federal Reserve Act had a specific reporting requirement about the growth of the monetary aggregates. It called for the Fed to submit a report to Congress and then testify in February and July of each year, laying out its plans for money growth for the current and next calendar years.

The legislation required only that the Federal Reserve report its plans for money growth, not that the Fed set the plans in any particular way. The Fed had discretion to choose the growth rates of the aggregates. But if the Fed deviated from the plans, it had to explain why. If Federal Reserve policymakers determined that their reported objectives or plans, according to the words of the act, “cannot or should not be achieved because of changing conditions,” they “shall include an explanation of the reasons for any revisions to or deviations from such objectives and plans.”

The reporting requirement was fully repealed in 2000 because over time the data on money growth had become less reliable as people found alternatives to money—such as credit cards or money-market mutual funds—for making payments. The Fed subsequently started focusing more on the interest rate rather than money growth when it made its policy decisions. In itself, therefore, it was perfectly reasonable to remove the reporting requirement for money growth in

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