The Fed’s Letter to Congress and the FORM Debate

In advance of a House vote on the Fed Oversight Reform and Modernization (FORM) Act, Fed Chair Janet Yellen sent an open letter to Speaker Paul Ryan and Minority Leader Nancy Pelosi objecting to the legislation and generating a lot of media interest.  The letter repeats views expressed by Janet Yellen in Congressional testimony, which I have commented on before, but misunderstandings and misleading statements about the legislation persist. Let me  illustrate by focussing on Section 2 of the Act as does Yellen in the letter.

Section 2 of the Act 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. The Act does not require that the Fed use a particular rule or strategy.  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. The reform reflects economic evidence and practical experience that policy works best when it adheres closely to a clear rule or strategy.

Thus, under the legislation the Fed would set forth its strategy, but it would not be required to choose a mathematical formula or any other particular rule or strategy. Yet the Yellen letter says that the FORM act “would require the Federal Reserve to establish a mathematical formula” for adjusting the stance of monetary policy. That’s not true.

To improve communication the Act requires that the Fed compare its rule or strategy with a reference rule, which happens to be the so-called Taylor rule. However, describing the difference between a particular rule or strategy and this reference rule is a common and routine task for the Fed. Many at the Fed already make such comparisons including Chair Yellen. In fact, the Fed staff paper cited by Yellen in her letter makes extensive use of the rule to measure the impact of the Fed’s unconventional policies. As Janet Yellen stated in 1996 “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”

To be clear nothing in the bill would require the Fed to follow a Taylor rule. Nevertheless, much of the letter is devoted to the therefore irrelevant claim that if the Fed had adhered to that rule after the recession then the results would have been worse. But the Yellen letter ignores the much more important view that if the Fed had adhered to that rule, or more generally to the rule-like policy of the 1980s and 1990s,  in the years leading up to the 2007-2009 recession, then we would likely have avoided the search for yield and risk taking that led to the deepness of the recession and the tragic rise of unemployment in the first place. In other words, the letter ignores the harm that came from deviating from rules-based policy in the period leading up to the crisis

The letter also says that “no simple policy rule has yet been devised that would adequately address the effective lower bound on the policy rate.” But the zero lower bound was not a reason to have deviated from rules-based policy in 2003-2005 and it is not a reason now, with the zero bound no longer binding. The zero bound appears to have been binding in 2009, but the zero bound was taken into account in policy rule design research long ago, as in my 1993 book Macroeconomic Policy in a World Economy; this research led to the view that interest rate rules are best thought of as part of a more encompassing rule in which the instrument becomes money growth in deflationary or hyper inflationary situations as in my 1996 paper Policy Rules as a Means to a More Effective Monetary Policy. Moreover the rule proposed by David Reifschneider and John Williams in the late 1990s was designed to deal with the lower bound

The letter says the legislation would “cast aside the bipartisan approach” of the late 1970s.  But it was in 1977 that very similar reporting and accountability legislation was put into the Federal Reserve Act by congress and signed by the president; though originally strongly objected to by the Fed, the legislation required the Fed to report on its policy in terms of ranges for money growth. So there is bipartisan precedent for this type of legislation. The previous legislation did not specify exactly what the numerical settings of these ranges should be (that is similar to the proposed legislation), but the greater focus on the money and credit ranges were helpful in the disinflation efforts of the 1980s.  When the requirement for reporting ranges for the monetary aggregates were removed from the law in 2000, nothing was put in its place. The reform in Section 2 of FORM would fill that void.

The Yellen letter discusses the Government Accountability Office quite a lot.  The Fed has objected to an expanded auditing role for the GAO many times before, but the issues here are different. There would be no GAO audit under Section 2 assuming that the Fed complied with the law, and concerns about compliance are likely the reason why the GAO appears in Section 2. I am sure that there are alternative compliance methods that the Fed could propose, and more generally, constructive suggestions and comments from the Fed that could improve the legislation.

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