President Obama just widened the race for Fed chair. Up on Capitol Hill he mentioned Don Kohn along with Larry Summers and Janet Yellen. So we should widen the hunt for things that Don has said that help answer the key question I asked in a recent blog about Summers and Yellen: “who is more most likely to implement a monetary policy that will help keep us out of a serious financial crisis, and create price and output stability more generally. In other words who will implement a more predictable, less interventionist, more rules-based monetary policy strategy of the kind that has worked well when tried, as in the 1980s, 1990s and until recently?”
I know that Don has thought deeply about rules-based monetary policy. As Don put it in a 2007 speech at the Dallas Fed, he and I “have spent countless hours discussing how the Federal Reserve arrives at decisions about monetary policy and how it should arrive at decisions. Those conversations began in earnest in the late 1980s, when [I] was on the Council of Economic Advisers, and they have continued to the present day. They have occurred not only in offices and classrooms in Washington and Stanford and at numerous conferences around the globe, but also around dinner tables in Washington and Palo Alto and on hiking trails from Vermont to Wyoming.”
In that same speech Don listed “Three Benefits of Simple Rules in Monetary Policymaking.” I’ll just quote the key phrases without comment, so you can get a sense of what Don says in his own words.
First, “a simple rule…can provide a useful benchmark for policymakers. It relates policy setting systematically to the state of the economy in a way that, over time, will produce reasonably good outcomes on average.”
Second, “simple rules…help financial market participants form a baseline for expectations regarding the future course of monetary policy.”
Third, “simple rules can be helpful in the central bank’s communication with the general public. Such an understanding is important for the transmission mechanism of monetary policy.”
But Don points out that “Simple rules have limitations…” He mostly uses the Taylor rule as an example:
First, “the use of a Taylor rule requires that a single measure of inflation be used to obtain the rule prescriptions…. To be sure, over long periods, most of these measures behave very similarly. But policy is made in the here and now, and the various indexes can diverge significantly for long stretches, potentially providing different signals for the appropriate course of monetary policy.
Second, “the implementation of the Taylor rule and other related rules requires determining the level of the equilibrium real interest rate and the level of potential output; neither of them are observable variables, and both must be inferred from other information.”
Third, “using simple rules for monetary policymaking stems from the fact that, by their nature, simple rules involve only a small number of variables. However, the state of a complex economy like that of the United States cannot be fully captured by any small set of summary statistics.”
Fourth, “simple policy rules may not capture risk-management considerations. In some circumstances, the risks to the outlook or the perceived costs of missing an objective on a particular side may be sufficiently skewed that policymakers will choose to respond by adjusting policy in a way that would not be justified solely by the current state of the economy or the modal outlook for output and inflation gaps.”
Don “offered this analysis in the spirit of so many of the discussions” I had with him. While his bottom line was that “it’s not so simple to use simple rules!” you really get the sense that he would like to do so.