The Case for a Rules-Based Fed

Neel Kashkari is wrong. My proposed rules-based reform of the Fed would not be run by a computer.

By John Taylor. Excerpts:

"in a recent Journal op-ed, Neel Kashkari, president of the Minneapolis Fed...joined the debate by arguing against rules-based reform."

"This is a false characterization of the reforms that I and many others support. In those reforms the Fed would choose and report on its strategy, which would neither be mechanical nor run by a computer."

"the Fed moved away from a rules-based policy in 2003-05 when it held the federal-funds rate well below what was indicated by the favorable experience of the previous two decades. The results were not good. The excessively low rates brought on a risk-taking search for yield and excesses in the housing market."

"During the panic in the fall of 2008, the Fed did a good job"

"But then the Fed moved sharply in an unconventional direction by purchasing large amounts of Treasury and mortgage backed securities, and by holding the fed-funds rates near zero for years after the recession was over.

These policies were ineffective. Economic growth came in consistently below what the Fed forecast and much weaker than in earlier recoveries from deep recessions. Such policies discourage lending by squeezing margins, widen disparities in income distribution, adversely affect savers and increase the volatility of the dollar."

"Because this 12-year period represents a deviation from the more rule-like and predictable monetary policy that worked well in the 1980s and ’90s, many are calling for the Fed to normalize and reform."

"Mr. Kashkari, by contrast, argues that a rules-based approach would shackle Fed policy makers, forcing them to “stick to” a rigid rule “regardless of economic conditions.” That too is false. The Fed could change or deviate from its strategy if circumstances changed, but the Fed would have to explain why. And he wrongly claims that rules cannot take account of changes in productivity growth."

"The rule calls for central banks to increase interest rates by a certain amount when price inflation rises and to decrease interest rates by a certain amount when the economy goes into a recession.

Mr. Kashkari ignores the hundreds of research papers that have been written on the effectiveness and robustness of such a rule"
"Yet in a recent empirical study, Alex Nikolsko-Rzhevskyy of Lehigh University and David Papell and Ruxandra Prodan of the University of Houston divided U.S. history into periods, like the 1980s and ’90s, where Fed policy basically adhered to the Taylor rule and periods, like the past dozen years, where it did not. Unemployment was 1.4 percentage points lower on average in the Taylor rule periods, and it reached devastating highs of 10% or more in the non-Taylor rule periods."

"they evaluate policy as a continuing contingency strategy—the essential characteristic of monetary rules—rather than as a one-time policy change,"

"Had the Fed not deviated from rules-based policy before the crisis, unemployment would not have increased so much."

"below-rule interest rates in other countries that were connected to crises."