New Legislation Requires Fed to Adopt Policy Rule

A lot of research and experience shows that more predictable rules-based monetary policy leads to better economic performance—both in terms of price stability and steadier-stronger employment and output growth.  But in practice there have been big swings in Fed policy between rules and discretion, with damaging results as in the 1970s and the past decade of a financial crisis, great recession and slow recovery.  This experience—especially the swing from rules to discretion in the past decade—demonstrates the need for legislation requiring the Fed to adopt rules for setting its policy instruments.

So it is good news that today the ‘‘Federal Reserve Accountability and Transparency Act of 2014” was introduced into Congress. It requires that the Fed adopt a rules-based policy.

In particular, Section 2, the first main section of the Act, titled “Requirements for Policy Rules for the Federal Open Market Committee,” would require that the Fed “submit to the appropriate congressional committees a Directive Policy Rule… which shall describe the strategy or rule of the Federal Open Market Committee for the systematic quantitative adjustment of the Policy Instrument Target to respond to a change in the Intermediate Policy Inputs.”  Thus the rule would describe how the Fed’s policy instrument, such as the federal funds rate, would change in a systematic way in response to changes in the intermediate policy inputs, such as inflation or real GDP. The rule would also have to be consistent with the setting of the actual federal funds rate at the time of the submission.

The Fed, not Congress, would choose its Directive Policy Rule and how to describe it.  But if the Fed deviated from its rule, then the Chair of the Fed would have to “testify before the appropriate congressional committees as to why the [rule] is not in compliance.”  The Comptroller General of the United States would determine whether or not the Directive Policy Rule was in compliance and report to Congress.

To provide some flexibility the legislation allows for the Fed to change the rule or deviate from it if the Fed thought it was necessary. As stated in the legislation: “Nothing in this Act shall be construed to require that the plans with respect to the systematic quantitative adjustment of the Policy Instrument Target be implemented if the Federal Open market Committee determines that such plans cannot or should not be achieved due to changing market conditions.” But “Upon determining that plans…cannot or should not be achieved, the Federal Open Market Committee shall submit an explanation for that determination and an updated version of the Directive Policy Rule.”

An interesting part of the requirement is that the “the report to the congressional committees must include a statement as to whether the Directive Policy Rule substantially conforms to the Reference Policy Rule and with an explanation or justification if it did not. What is the reference policy rule?

According to the legislation “The term ‘Reference Policy Rule’ means a calculation of the nominal Federal funds rate as equal to the sum of the following: (A) The rate of inflation over the previous four quarters. (B) One-half of the percentage deviation of the real GDP from an estimate of potential GDP. (C) One-half of the difference between the rate of inflation over the previous four quarters and two. (D) Two.

So it’s the Taylor Rule.  Of course the legislation does not require the Fed to follow the Taylor rule, but only to describe how it might differ.  Describing this difference is a task undertaken as a matter of course by most researchers working on different policy rules, so it is a straightforward task for the Fed.

This bill along with the several following sections on cost-benefit analysis and transparency was introduced as HR 5018 by Bill Huizenga and Scott Garret, members of Congress from Michigan and New Jersey, respectively. It is not clear how the Fed will react to this legislation. Some will likely object, but many at the Fed favor a more rules-based policy. In many respects the bill simply replaces reporting requirements for the policy instruments that were removed from the Federal Reserve Act in 2000 as I described here.  If the legislation were passed into law, I am sure the Fed could make it work to a good end.

I will be testifying on the legislation at a hearing at the House Financial Service Committee on Thursday at 10 am.

Posted in Monetary Policy

Stanford’s Economics 1 Now Coming Online

I have been teaching economics at Stanford for many years. Economics 1 is one of my favorite courses, and it’s been one of the most popular courses at Stanford.  I usually teach it in a large lecture hall with hundreds of students and occasionally I have guest lecturers like the famous economist Milton Friedman when he was alive.  And sometimes I goof around, as when I brought my baby granddaughter to be the guest lecturer.  One year Tiger Woods took the course and he learned the famous concept of opportunity cost so well that he left Stanford and joined the pro-golf tour.

This summer starting on June 24 we are giving an open online version of that on-campus course. People can register here for the open course. We have packaged the course in a new, different, and I think effective way as follows:  Each day just after giving a 50-minute lecture to hundreds of students, I went to a recording studio in the David Packard Building on the Stanford campus and gave the same lecture but divided into smaller segments, designed for easier online viewing. We then mixed in graphs, photos, and other illustrations, just as they would appear in the large lecture. And we captioned and indexed each video so it could be easily searched. We then put these videos on a new Stanford online platform “” Then we added review and study material to the platform and set up discussion groups. We provided links to make a complete self-contained course.

The course covers all of economics at a basic level. It stresses the key idea that economics is about making purposeful choice with limited resources and about people interacting with other people as they make these choices. Most of those interactions occur in markets, and this course is mainly about markets, including the market for bikes on campus, or labor markets, or capital markets.  We will show why free competitive markets work well to improve people’s lives and how they have removed millions from people from poverty around the world, with many more, we hope, still to come.

People who participate in the open online course and take the short quizzes following each video will be awarded a Statement of Accomplishment. As with many open online courses, this one runs in parallel with a for-credit Stanford Economics 1 course that also includes a midterm test, a final exam, problem sets, and homework, which are all graded and count toward a final grade and credit for Stanford students. An unique feature of this for-credit course is that it is also offered online–using the same Stanford online platform–to Stanford students and incoming freshman who happen to be off campus this summer.


Posted in Teaching Economics

Policy Rules When Money Still Matters

In an interesting recent paper and blog post “Money Still Matters,” Michael Belongia and Peter Ireland report new empirical results with relevance to monetary policy.  They show that the Divisia index of the money supply (not M1 or M2) has effects on the economy over and above the effects of the short term interest rate.

The results suggest that central bankers—as they look into alternative strategies for monetary policy—should consider some kind of money growth rate rule, at least as a supplement to the interest rate rules which have been the focus of research and practice for many years.

I agree with this view, and have for a long time pushed back against the trend of central banks—including the Fed—to ignore money growth.  In situations where the interest rate hits the lower bound or more generally in situations of deflation or hyperinflation, I have argued that central banks need to focus on a policy rule which keeps the growth rate of the money supply steady. In a 1996 paper, for example, I recommended that “Interest rate rules need to be supplemented by money supply rules in cases of either extended deflation or hyperinflation.”

Belongia and Ireland point out that my early work on policy rules in the 1970s was completely in terms of money growth rules.  That is true, but why the change toward interest rate rules? In their brief history of the 1980s and 1990s, Belongia and Ireland seem to provide an answer with a summary of my 1993 policy rule paper which they say “showed how well the Fed adjusted its funds rate target in response to movements in output and inflation during the late 1980s and early 1990s. The debate was closed. A new consensus, prevailing to this day, placed interest rates instead of money at the heart of all monetary policy discussions.”

But that Fed decisions were fairly close to some interest rate rule during such a short span of time was not my rationale for proposed interest rate rule.  Rather research in monetary theory was the rationale. It was the implication of empirically estimated structural monetary models (with rational expectations and rigidities) that I was developing and working with in the 1980s.  They had exchange rates and long term interest rates as well as short term interest rates with both internal and external dynamic stochastic shocks.

These models showed that interest rates rules would work better, at least with the range of shocks observed in the United States.  This result first came out of research I was doing at the Philadelphia Fed with Nicholas Carlozzi, but the close connection between money growth rules and interest rate rules was very important in my view and I stressed it often. Different types of models and views on the monetary transmission mechanism led to similar conclusions so it was a robust result.  In one of his last research papers Milton Friedman argued that the Taylor rule for the interest rate worked well because it was a way to keep the growth rate of the money supply constant, another way to make the connection between money growth rules and interest rate rules.

I argued that interest rate rules need to be placed within a band. Outside that band the central bank should rely on money growth rules.  In simulating the multi-country empirical model at Stanford in the 1980s we took account of the zero bound on the interest rate, switching to money growth. And this is what I recommended in 2009.  However, the series of on-and-off quantitative easing that began in 2009 was never aimed at keeping money growth steady or even at keeping it from falling, which is clear in the erratic behavior of M2 (see here) or Divisia, as Belongia and Ireland show.

In order to go from the interesting empirical results of Belongia and Ireland to a policy strategy, more research on alternative policy rules is needed.  Are there structural models where alternative policy rules with money growth work better? What are those rules? Are they robust to other types of models? Such research led to the types of policy rules that are now the focus of so much attention. In my view it will lead to improvement in these rules, and in this regard it is useful to recall where policy rules for the interest rate came from in the first place.

Posted in Monetary Policy

Ten Amusingly Irreverent Tweets at Conference on Fed

So many members of the financial press were having a good time tweeting at the Fed Centennial conference last week at Stanford that, according the “TweetReach Report,” about 1 million Twitter accounts were reached and 10 million tweets were delivered about the hashtag #hooverfedconference.  Here is a photo of the post-conference press conference

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Many tweets were serious and formed the basis for longer articles, but most everyone got a kick out of the funny sarcastic ones. Here is my list of 10 with the most amusingly irreverent sense of humor.





Posted in Teaching Economics

An Essay on Gary Becker for the Hoover Digest

I wrote this short essay on Gary Becker for the Hoover Digest where it will appear in a forthcoming issue:

Gary Becker was “the greatest social scientist who has lived and worked in the last half century.” So declared Milton Friedman a decade ago, and when Gary Becker died earlier this month at the age of 83 the outpouring of praise from his friends and colleagues reminded us why: His unique style of economic analysis, firmly rooted in facts, yielded a host of truly amazing ideas and predictions from the growth effects of investment in human capital to recent changes in the distribution of income and intergenerational mobility. Many of his ideas—including that free competitive markets help combat discrimination and that simple cost-benefit calculations applied to children help determine fertility rates—were originally controversial, but are now widely accepted. I regularly teach them to beginning students in the Economics 1 course at Stanford.

In the rush to describe Gary’s contributions to economics we sometimes forget his deep interest in economic policy. He took economics very seriously, no less so when he applied it to public policy.  For Gary, more than for most economists, economics and economic policy were inseparable.  When he talked to a politician running for office or to a public official already in office, his policy recommendations would be exactly the same as if he were speaking to a student, a colleague, or the readers of his Business Week columns, blogs, and research papers.  There was no difference between his economics and his school of economics.

This close connection between economics and economic policy was most apparent to me during the times of year that he was in residence at the Hoover Institution, which itself has had a focus on policy. For several decades Gary would spend a number of weeks or months of each year at Hoover, and he kept in touch with Hoover policy research projects at other times, from joining in oped columns with other Hoover fellows to commenting on their ideas. His Hoover office was next to mine, and I will miss him, his advice, and our conversations greatly as will many of his other good friends.

Gary’s association with the Hoover Institution began in the 1970s when he served on the influential Domestic Policy Advisory Committee along with Milton Friedman, George Stigler, and James Buchanan all who would also become Nobel prize winners.  He officially became a Hoover Senior Fellow in 1990.

During his stints on the west coast Gary regularly attended the annual Economists Weekend at Villa Cyprus on the Monterey Peninsula hosted by George Shultz.  There he would interact and vigorously debate the hot policy topics of the day with Shultz, Friedman and other economists, but also with practical business people engaged in economics and finance like Walter Wriston of Citibank and Dick Kovacevich of Wells Fargo.  Breakfasts, lunches and dinners became serious seminar-like policy conversations with rejuvenating breaks to play tennis or hike along the rocks and surf. Policy topics would change over the years, but the seriousness with which Gary confronted them did not.

Another example of Gary’s focus on economic policy was the 1996 presidential campaign where Gary was a key economic adviser to candidate Bob Dole.  He focused mainly on education and training issues, but weighed in on all other economic issues from the budget to tax policy. From my vantage point as another adviser, I can tell you that Gary’s advice could not have been more closely aligned to his economic research, with absolutely no hedging or bending if politics threatened to push out good economics. In a campaign memo he wrote: “The value of education, training, and other human capital is no less than that of machines and other physical capital, and almost certainly it is larger,” adding to another memo “We have seen income distribution widen in the United States and other countries” and that reflects “a particular problem with the education and training of those at the lower end of the income distribution.”  He advised that “The aim of policy reforms in this field should be to help stimulate economic growth by encouraging better quality and more effective schooling and training, especially for those at the bottom and middle of the human capital distribution.”  This “will both raise economic growth and also reduce inequality in earnings.”

So long before its recent popularity in policy and political circles, Gary was diagnosing and looking for solutions to income distribution problems.  Indeed some of his most recent work at the Hoover Institution was on income distribution. In a paper presented at the Hoover Economic Policy Working Group last year he applied his unique approach to the problem—one could say he Beckerized the problem—and uncovered a natural connection between changes in the cross sectional distribution of income and changes in intergenerational income mobility.

The recent financial crisis led many to question basic economic principles, but Gary fought back. In the a September 2011 Wall Street Journal article headlined “The Great Recession and Government Failure,” he said that “The origins of the financial crisis and the Great Recession are widely attributed to ‘market failure’….government behavior also contributed to and prolonged the crisis. The Federal Reserve kept interest rates artificially low in the years leading up to the crisis….Regulators who could have reined in banks instead became cheerleaders for the banks….’government failure’ added greatly to its length and severity, including its continuation to the present. In the U.S., these government actions include an almost $1 trillion in federal spending that was supposed to stimulate the economy.”

The “blame the markets not the government” mantra was enough to discourage anybody.  I remember going into his office and griping about it. But Gary could see people’s perceptions changing, and he was pleased that the revival of a highly interventionist approach to economic policy had not captured all of the profession. Gary remained optimistic to the end, and that should be an inspiration to us all.

Posted in Teaching Economics

New Conference on Fed and Rules-Based Policy: A Preview

Today starts a two day conference at Stanford’s Hoover Institution on monetary policy. It’s part of the Fed Centennial. Here is the full agenda which includes talks and commentary by Esther George, Tom Sargent, Charles Plosser,  John Williams, Jeff Lacker, Ed Prescott, Allan Meltzer, Niall Ferguson, Maury Obstfeld, Barry Eichengreen, George Shultz, Monika Piazzesi,  Athanasios Orphanides, Otmar Issing, Martin Schneider and others.

The main purpose of the conference is to put forth and discuss a set of policy recommendations that are consistent with and encourage a more rules-based policy for the Fed, and would thus improve economic performance, especially in comparison with the past decade.  The idea is to base these recommendations as much as possible on economic theory, on data, and especially on the history of the past century. It is natural to do so at the time of the Centennial of the Fed.

The recommendations in the technical papers prepared in advance of the conference have set the stage for the discussion and the panels to come. Here is quick summary of the recommendations of the papers prepared in advance.   Links are on the agenda.

In his paper for the first session, John Cochrane recommends three things: first that the short-term interest rate should be in the future determined by setting interest rate on reserves; second, that the rate should adjusted according to a policy rule; and third, that the resulting large reserve balances at the Fed should not be used for discretionary interventionist policies, such as quantitative easing, which he argues have done little good.  We may hear some discussion about whether political economy considerations render the third point hard to achieve in practice.

David Papell’s paper provides a statistical foundation for the overall theme. He uses formal statistical techniques to determine when in history monetary policy was rule-like, and he finds the rule-like periods coincide remarkably well with periods of good economic performance.  A clear policy recommendation emerges directly from his statistical findings.

Marvin Goodfriend’s historical review of the Fed’s first century leads him to recommend a new “Fed-Treasury Credit Accord” which would have a “Treasuries only” asset acquisition policy with exceptions only in the case of well-specified lender of last resort actions.  This would deal with the recurrent mission creep problem where a limited purpose institution takes on other actions for which it was not granted independence.

Michael Bordo’s key policy recommendation nicely dovetails with Marvin Goodfriend’s. He recommends, again based on an examination of the history of the Fed, that, in order to prevent and deal with crises, the central bank needs to lay out and to announce a systematic rule for its lender of last resort actions, linking his policy recommendation to what has worked and what has not worked in practice.

Lee Ohanian puts monetary policy in the context of big real economic shocks that are caused in large part by other economic policies—a situation which many have argued characterizes the economic situation today.  He finds that discretionary Fed policy responses to these major shocks have in some cases, negatively impacted the economy. Also timely is his warning that overestimating the risks of deflation can lead monetary policy astray.

Andrew Levin recommends that a good communications strategy for systematic monetary should recognize that that the reference policy rule may change over time.  He usefully focuses on the possibility of  a change in the terminal or equilibrium federal funds rate, such as a decline from 4 percent now assumed by most FOMC members to perhaps as low as 2 percent as Richard Clarida has argued in a new paper with Bill Gross his colleague at PIMCO.

And we will also hear from Richard Clarida that policy rules work quite well in an international setting and lead to a smoother operating global monetary system with smaller spillovers.  He also argues that a policy rule framework will “re-emerge as the preferred de facto if not de jure construct for conducting, evaluating, and ultimately for communicating monetary policy”   Here his use of the word de jure is important for it suggests that some legislation may be needed to bring these reforms about and keep them in place.  That is an important and timely issue which will be discussed in the next two days.

Posted in Monetary Policy

Market Failure and Government Failure in Leading Economics Texts

A new review of 23 leading Principles of Economics texts reveals huge differences in the coverage of government failure versus market failure.  Jim Gwartney, who is the author of a leading text with a strong emphasis on public choice, along with his colleague Rosemarie Fike, conducted the review and posted the results here.

Jim and Rosemarie went through each of the 23 introductory texts looking for and tabulating references to various types of market failure and government failure. As they explain in the paper they also categorized the explanations of market failure (say due to externalities, public goods, market power,…) and government failure (say due to special interests, short-sightedness, rent-seeking,…). Different people can have different views about the criteria and about models of public choice and government developed by James Buchanan, George Stigler, and others.  But the paper endeavors to describe the methodology carefully, and I recommend reading it to get an understanding of the results.

The following is Table 3 of the paper. It shows the ratio of page coverage on government failure to page coverage on market failure in each text.  Other metrics reported in the paper give similar results.Gwartny Fike Table 3

The Paul Krugman-Robin Wells book is tied with the lowest ratio (0.00) along with the Robert Hall- Marc Leiberman book.  With more references to government failure, Gwartney, Cowen-Tabarrok, Arnold, and McEachern have much higher ratios.  It is interesting that the ratios in Baumol-Blinder and Mankiw are quite low, especially in comparison the Samuelson-Nordhaus ratio which is just a bit below the average. The ratio in my book with Akila Weerepana is a bit above the average.

Reviews like this can affect future texts and revisions as authors and users become more aware of the overall coverage in comparison with the market.  My guess is that future reviews will show an increase in the average ratio and some small reduction in the variance which preserves the overall diversity.


Posted in Teaching Economics