Was Janet Yellen Test Driving the Policy Rule Bill?

In a speech last week Fed Chair Janet Yellen made use of policy rules, and in particular the Taylor rule, to explain her views on normalizing policy. This comes on the heels of Fed Vice-Chair Stanley Fischer’s reference to the Taylor rule in a speech earlier in the week, two influential Bloomberg View columns by Clive Crook (here and here) making the case for the Fed to use such rules, the Shadow Open Market Committee’s unanimous recommendation to use rules that way, and continued discussion of a bill in Congress which would require the Fed to state its rule and compare it with a reference rule.

In fact, Janet Yellen’s discussion of how current and upcoming policy might differ from a reference rule (the Taylor Rule) is not unlike what you  might see if the policy rule legislation under consideration in Congress became law.  So one can think of her discussion as sort of test drive or trial run. If so, it raises a number of questions.

Let me first quote from the relevant section of Janet Yellen’s speech starting on page 7 and embedding an important explanatory footnote at the end:

“Even with core inflation running below the Committee’s 2 percent objective, Taylor’s rule now calls for the federal funds rate to be well above zero if the unemployment rate is currently judged to be close to its normal longer-run level and the “normal” level of the real federal funds rate is currently close to its historical average. But the prescription offered by the Taylor rule changes significantly if one instead assumes, as I do, that appreciable slack still remains in the labor market, and that the economy’s equilibrium real federal funds rate–that is, the real rate consistent with the economy achieving maximum employment and price stability over the medium term–is currently quite low by historical standards. Under assumptions that I consider more realistic under present circumstances, the same rules call for the federal funds rate to be close to zero…

“For example, the Taylor rule is Rt = RR* + πt + 0.5(πt -2) + 0.5Yt, where R denotes the federal funds rate, RR* is the estimated value of the equilibrium real rate, π is the current inflation rate (usually measured using a core consumer price index), and Y is the output gap. The latter can be approximated using Okun’s law, Yt = -2 (Ut – U*), where U is the unemployment rate and U* is the natural rate of unemployment. If RR* is assumed to equal 2 percent (roughly the average historical value of the real federal funds rate) and U* is assumed to equal 5-1/2 percent, then the Taylor rule would call for the nominal funds rate to be set a bit below 3 percent currently, given that core PCE inflation is now running close to 1-1/4 percent and the unemployment rate is 5.5 percent. But if RR* is instead assumed to equal 0 percent currently (as some statistical models suggest) and U* is assumed to equal 5 percent (an estimate in line with many FOMC participants’ SEP projections), then the rule’s current prescription is less than 1/2 percent.”

So the main argument is that if one replaces the equilibrium federal funds rate of 2% in the Taylor rule with 0%, then the recommended setting for the funds rate declines by two percentage points. The additional slack due to a lower natural rate of unemployment is much less important.  But little or no rationale is given for slashing the equilibrium interest rate from 2% percent to 0%. She simply says “some statistical models suggest” it.  In my view, there is little evidence supporting it, but this is a huge controversial issue, deserving a lot of explanation and research which I hope the Fed is doing or planning to do.

If one can adjust the intercept term (that is, RR*) in a policy rule in a purely discretionary way, then it is not a rule at all any more.  It’s purely discretion. Sharp changes in the equilibrium interest rate need to be treated very carefully, as Andrew Levin pointed out recently.

Another important issue is that Janet Yellen does not make the argument here that the coefficient on the output gap in the Taylor rule should be 1.0 rather than 0.5 as she has in previous speeches advocating a lower rate.  The argument is different here, and no reason for dropping the old argument is given.  Perhaps the reason is that the gap is small now, so the coefficient on the gap does not make much difference.  This gives the appearance that one is changing the rule or the inputs to the rule to get an answer. I do not think that reason would go over well in Congressional testimony.


Posted in Monetary Policy

Bernanke Says “The Fed Has a Rule.” But It’s Only Constrained Discretion and It Hasn’t Worked

In response to a question about the policy rules bill at Brookings recently, Ben Bernanke remarked that the “The Fed has a rule.” His claim surprised quite a few people, especially given the Fed’s resistance to the policy rules bill, so he then went on to explain: “The Fed’s rule is that we will go for a two percent inflation rate. We will go for the natural rate of unemployment.  We will put equal weight on those two things. We will give you information about our projection, our interest rates. That is a rule.”  But the rule that Bernanke has in mind is not a rule for the instruments of the kind that I and many others have been working on for years, or that Janet Yellen referred to in speeches over the years, or that Milton Friedman made famous.

Rather the concept that he has in mind is called “constrained discretion,” a term which he dubbed long ago in an effort to distinguish it from the idea of a rule for the instruments such as Milton Friedman’s which he sharply criticized. Bernanke first used the term in a 1997 paper with Rick Mishkin and later in a 2003 speech shortly after joining the Fed board.  In fact, it is a concept he has favored from before the time that I first presented the Taylor rule.

It is that all you really need for effective policy making is a goal, such as an inflation target and an unemployment target. In medicine, it would be the goal of a healthy patient. The rest of policy making is doing whatever you as an expert, or you as an expert with models, thinks needs to be done with the policy instruments. You do not need to articulate or describe a strategy, a decision rule, or a contingency plan for the instruments. If you want to hold the interest rate well below the rule-based strategy that worked well during the Great Moderation, as the Fed did in 2003-2005 after Bernanke joined the board, then it’s ok as long as you can justify it at the moment in terms of the goal.

“Constrained discretion” is an appealing term, and it may affect discretion in some sense, but it is not inducing or encouraging a rule as the language would have you believe. Simply having a specific numerical goal or objective function is not a rule for the instruments of policy; it is not a strategy; it ends up being all tactics, all discretion.  Bernanke obviously likes the approach in part because he believes “the presumption that the Taylor rule is the right rule or the right kind of rule I think is no longer state of the art thinking.” There is plenty of evidence that relying solely on constrained discretion has in fact resulted in a huge amount of discretion, and that has not worked for monetary policy.  David Papell and his colleagues have shown empirically that it is during periods of rules-based policy, rather than periods of so-called constrained discretion, that economic performance has been good.

Posted in Monetary Policy

Central Banks Without Rules Are Like Doctors Without Checklists

Recent proposals for policy rules legislation have led to a fascinating replay of issues that have long been at the heart of the rules versus discretion debate. Larry Summers raised one in a debate between him and me at the American Economic Association meetings in Philadelphia and again at a conference at Stanford a week ago.  Here is how Larry started in Philadelphia (from the transcript in the Journal of Policy Modeling Vol. 36, Issue 4, 2014)

“John Taylor and I have, it will not surprise you…a fundamental philosophical difference, and I would put it in this way. I think about my doctor. Which would I prefer: for my doctor’s advice, to be consistently predictable, or for my doctor’s advice to be responsive to the medical condition with which I present? Me, I’d rather have a doctor who most of the time didn’t tell me to take some stuff, and every once in a while said I needed to ingest some stuff into my body in response to the particular problem that I had. That would be a doctor who’s [advice], believe me, would be less predictable.”

Much as the proponents of discretion in earlier rules versus discretion debates (Keynes and Hayek, Heller and Friedman), Summers argues in favor of relying on the all-knowing expert, a doctor who does not perceive the need for, and does not use, a set of guidelines, but who once in a while in an unpredictable way says to ingest some stuff or does something else.

I expressed my concern that Larry’s non-rules-based doctor would recommend the wrong stuff saying: “You know it would be great to have the all-knowing doctor that is there in every particular situation and just continues to do the right thing. But we have a lot of experience with economic policies; it’s not just model simulations, it’s historical. You know when things have worked better, [is] when they’re more predictable, more rules-based. You have the Great Moderation period, very clear in that respect. But I think the main thing here is we have theory, we have facts, and [they suggest]…the dangers of too much discretion.”

Greater doubts about Larry’s analogy with doctors come from direct experience and facts about medical care, especially surgery.  Indeed, there has been much progress in medical care over the years due to doctors using rules in the form of simple checklists, as described so well in a New Yorker article by Atul Gawande “The Checklist: If Something So Simple Can Transform Intensive Care, What Else Can It Do?” and in more detail in his book, Checklist Manifesto.  (Here is an interesting Daily Show  interview about his book.)  Simple checklists have proved to be invaluable for preventing mistakes, getting good diagnoses and appropriate treatments. Of course doctors need to exercise judgement in implementing checklists, but if they start winging it or skipping steps the patients usually suffer. (Here’s a surgery demo).

Practical experience and empirical studies show that checklist-free medical care is wrought with dangers just as rules-free monetary policy is.

Posted in Monetary Policy, Teaching Economics

Witness Allan Meltzer and the Ouija Board Analogy

Last week the Senate Banking Committee held a hearing about monetary reform and the need for “responsible oversight” of the Fed as Senator Richard Shelby, the Committee Chair, put it.  Allan Meltzer was a witness, and I sat next to him at the witness table listening carefully when he spoke.  Meltzer was remarkably clear, articulate and convincing, directly addressing Senators on the Committee, both Democrats and Republicans.  Indeed, both sides seemed to be listening carefully, in part because he was so obviously nonpartisan, supportive, for example, of a bill by Ranking Member Brown and Senator Vitter and for a lender of last resort proposal by Senator Elizabeth Warren about which he said,” I congratulate you, Senator Warren, for keeping this issue alive.”

Meltzer spent a lot of time explaining in simple terms the merits of the policy rules bill, especially in comparison with other reforms, including the Audit the Fed bill.  It’s worth listening to. Here are some highlights:

In his opening, Meltzer saidWe need change to improve the oversight that this Committee and the House Committee exercises over the Fed. You have the responsibility. Article I, Section 8 gives that to you. But you do not have the ability to exercise authority. You are busy people. You are involved in many issues. The Chairperson of the Fed is a person who has devoted his life to monetary policy. There is not any series of questions that you can ask on the fly that they are not going to be able to brush aside. That is why you need a rule. I agree with John Taylor about some of the reasons for the rule, but I believe one of the most important is that Congress has to fulfill its obligation to monitor the Fed, and it cannot do that now because the Chairman of the Fed can come in here, as Alan Greenspan has said on occasion, Paul Volcker has said on occasion, and they can tell you whatever it is they wish, and it is very hard for you to contradict them. So you need a rule which says, look, you said you were going to do this, and you have not done it. That requires an answer, and that I think is one of the most important reasons why we need some kind of a rule.”

Later in the hearing Senator Brown raised the issue of the audit the Fed bill, saying “Dr. Meltzer, be specific, if you would, about your thoughts about the Audit the Fed proposals,” and Melzer answered: “I think you do not get what you want. Suppose you knew everything. Suppose you found out that the Fed chooses its policy using a ouija board. What would you be able to do with that? What you want to do is get something which permits you to see that the policies that are carried out, are carried for the benefit of the public….The information you want has to come from having something very deliberate that you know they are going to do and that they tell you they are going to do, and you are able to say, ‘You did not do it,’ or, ‘You did.’”

Meltzer later elaborated:The problem with many of these proposals [release transcripts earlier, audit the Fed, etc.] is they don’t look at what would be the circumvention….What I think the Congress needs to do, it needs to face up to its responsibilities. Its responsibility is to be able to say to the Fed: ‘You told us you were going to do this, and you didn’t do it. Why?’ That’s what the rule gives you. That’s more important….You have to get a discipline in the Fed to tell you what it is going to do and then do it.” At this point Senator Shelby interrupted: “That is more important, isn’t it?” and Meltzer answered “That is more important than any other single thing you can do. You do not have the ability now to monitor them.”

Posted in Monetary Policy, Regulatory Policy

Which Fed Bill Would Milton Friedman Have Liked?

Writing last week on the Cato at Liberty blog, Steve Hanke argued that Milton Friedman would have supported the “Audit the Fed” bill recently introduced in the Senate.  Steve’s reasoning is based on Friedman’s 1962 essay “Should there be an Independent Monetary Authority?” where Friedman said, as Steve pointed out, that “The case against a fully independent central bank is strong indeed.”  However, in that same essay Friedman concluded—based on the history and experience with central banking in many countries—that legislating rules for the instruments of policy was the preferred alternative.

For this reason, it is very likely that Milton Friedman would have preferred the policy rules bill rather than the Audit the Fed bill.  The policy rules bill is Section 2 of HR 5018 that passed the house Financial Services Committee last year and that the Senate Banking Committee considered in a hearing last week This bill would require that the Fed “describe the strategy or rule of the Federal Open Market Committee for the systematic quantitative adjustment” of its policy instruments. It would be the Fed’s job to choose the strategy and how to describe it. The Fed could change its strategy or deviate from it if circumstances called for a change, but the Fed would have to explain why.

Such a bill would meet the goal enunciated by Milton Friedman.  As he explained in Capitalism and Freedom, (p. 53) he preferred “legislating rules for the conduct of monetary policy that will have the effect of enabling the public to exercise control over monetary policy through its political authorities, while at the same time it will prevent monetary policy from being subject to the day-by-day whim of political authorities.”

As Steve emphasized “we don’t know for certain” what Milton would have thought, but in my view there is substantial evidence that he would have liked something like the policy rules bill.

Posted in Monetary Policy

Liberate the Recovery

My piece in today’s Wall Street JournalA Recovery Waiting to Be Liberated,” starts with data showing that economic growth last year was in the end disappointing again.  So far this year it looks even worse: Macroeconomic Advisers one of the best shops for now-forecasting, estimates only 1.9% in the first quarter of this year after light vehicle sales in February were disappointing.  We need to get started with the reforms.

Another way to think about work by Chris Erceg and Andrew Levin (mentioned in the WSJ article) is that were it not for the unusual drop in the labor force, the unemployment rate would be 3 percentage points higher, say 8.7% rather than 5.7%.

So in several ways the U.S. economy resembles an economy at the bottom of a recession ready for a post-recession boom.  This is because the economy has crawled along at a pace no greater than the pre-recession trend, leaving a gap of unrealized potential that can be closed with rapid growth for a few years

Posted in Slow Recovery

Janet Yellen’s Speech on Policy Rules

For many years, going back to the days before Google and Google Scholar helped us find and keep track of things, I created a monetary policy rule home page with links to papers, articles and speeches on policy rules, including a written version of a 1996 speech by Janet Yellen on the Taylor rule.

Janet Yellen’s  speech is one of the clearest, most sensible, and most supportive analyses ever written about the Taylor rule.  I strongly recommend reading it, especially pages 4 to 11, in light of the recent congressional interest in policy rules.  She describes the rule, and then she carefully discusses “several desirable features” it has “as a general strategy for conducting monetary policy.”

She says that “the framework of a Taylor-type rule could help the Federal Reserve communicate to the public the rationale behind policy moves, and how those moves are consistent with its objectives.”  She mentions that she is “certainly not proposing the mechanical use of the Taylor rule.” And she adds correctly that “Nor would Taylor himself.”  She indicates that more work should be done to improve on such rules, and that in certain circumstances, which she describes, there could be deviations from the rule.

So one cannot help but be amazed by the exchange of views on the Taylor rule or rules in general between Janet Yellen and Richard Shelby, Chair of the Senate Banking Committee on Tuesday, and between her and Jeb Hensarling, Chair of the House Financial Services Committee on Wednesday.  In many respects, her speech makes the case for using monetary policy rules in the way that is called for by the policy rules bill that Shelby and Hensarling were asking her about and she seemed to be objecting to.  Some observers indicated that they seemed to be talking past each other.  But at the least there should be some common grounds for agreement that could form the basis for progress going forward.

Posted in Monetary Policy