Rules-based monetary policy received special focus during Janet Yellen’s inaugural hearing and the second panel immediately following on which I was a witness. In fact, the Chairman of the Committee, Jeb Hensarling, devoted a good part of his opening questioning of both Yellen and me to the subject, so the hearing transcripts will offer a rare opportunity to contrast different sides in the debate over whether it was appropriate to deviate from rules-based policy in recent years.
In his opening line of questions on why the Fed has deviated from a rules-based policy, Hensarling quoted from FOMC transcripts going back to January 1995 in which Janet Yellen said referring to the Taylor rule that “following such a rule…is what sensible central bankers do.”
A key part of Janet Yellen’s response was: “I have tried to argue and believe strongly that while a Taylor Rule…or something like it…provides a sensible approach in more normal times like the Great Moderation, under current conditions when this economy has severe headwinds from the financial crisis and has not been able to move the funds rate into negative territory that rule would have prescribed, that we need to follow a different approach and we are attempting through our forward guidance to be as systematic and predictable as we can possibly be…”
Having listened to this back and forth, I decided that when the time came for the second panel I would simply open with a 5-minute case for sticking to policy rules in recent years, instead of a 5-minute summary of my written testimony as I had planned and as is customary.
So after being recognized I opened as follows (as transcribed from a C-SPAN video clip):
“I would like to use my opening remarks to refer back to the initial set of questions and answers to Chair Yellen that you began with. They have to do with the role of policy rules in formulating of monetary policy. It seems to me that the case can be made that monetary policy would have been far better in the last few years had it been based on a predictable set of policy rules. Moreover I think that if policy moved in that direction we would more quickly move to a more sustainable higher growth rate. There has been a tremendous amount of research and historical work on policy rules. There continues to be interest to what you referred to as the Taylor rule, based on research of many people over many years, not just me. This research has indicated that when the Fed has followed rules close to that, performance has been very good. Historian Allan Meltzer in particular notes the period from 1985 to 2003 as one when the performance of the U.S. economy was extraordinarily good in historical comparison and that was a period when the Fed adhered pretty closely to one of these rules. I think if in the last 10 years policy had been guided this way, the performance would have been much better. If during 2003, 2004, and 2005, the Fed had followed a rule like this, we would not have had the excess risk taking, we would not have had the search for yield, we would not have had as much of a housing boom as we had, and therefore the financial crisis and the great recession would have been much less severe. If during the period since the financial crisis, the Fed had adhered to this kind of a policy rule, we would not have had to have the quantitative easing that has been so questionable, we would not have had to have the forward guidance that has been so debatable in its effects and the predictability of the economy I think would have been much better and therefore economic growth would have been better in those circumstances. And I want to emphasize such a rule would certainly not preclude the very important actions the Fed took during the panic of 2008, its classic lender of last resort role which helps stabilize the financial markets.
It’s because of this success of policy rules that I recommend that legislation be put in place to require the Fed to report on its policy rule. It would be a rule of its own choosing—that’s the responsibility of the Fed. But if it deviated in an emergency or for other reasons, the Fed through the Chair would be required to report to this committee and to the Senate Banking Committee about the reasons why. We’re not close to that right now, some argue that could be done on a procedural way rather than through legislation but I think there’s some promising signs that we could be going in that direction:
Number one, the Fed recently adopted a 2 % inflation target. That is exactly what the Taylor rule recommended 20 years ago. Moreover the European Central Bank, the Bank of England and the Bank of Japan have also adopted that target. There’s an international congruence which adds durability to that.
Number two, the forecast of the current FOMC, long term forecast for the interest rate is 4 %. If you combine that with the 2 % inflation target, you have a 2 % real interest rate. That’s exactly what that rule recommended 20 years ago.
There’s a consensus now that the reaction of central banks and the Fed in particular should be greater than 1 when inflation picks up. There is debate about what the reaction should be in the case of a recession. Some argue it should be larger, some smaller. And that is a difference of opinion.
But the fourth reason why I think we’re in a position to move in this direction, more so in the past is statements of Chair Yellen herself. She has indicated that policy rules like this are sensible, they’re good, they work well. She emphasizes: “That’s in normal times”. She would also argue these are not yet normal times.
There’s debate about when we will be back to normal or whether we are already back to normal. It’s seems to me therefore the debate is not over whether we should follow a policy rule like this, it’s about when. Thank you Mr. Chairman.
More on this debate can be found in my responses and Yellen’s responses to Hensarling’s questions, but the above gives a flavor of the discussion.