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.

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