Play By The Rules

Federal Reserve Chair Jerome Powell’s testimony at the House and Senate this week again had much to say about monetary policy rules. The focus on policy rules is encouraging, as it is a way to both get back on track and prevent further harmful deviations in the future, as was the focus of our recent May conference at Hoover and Stanford University

Consider for example the exchange at the Senate Committee on Banking. Housing and Urban Affairs between North Carolina Senator Thom Tillis, the acting ranking member, and Chair Powel on Wednesday June 22. 

According to the written record of his remarks, Senator Tillis said in his opening that: “Regarding the Fed specifically – though I am pleased you have begun taking the drastic action necessary to right the U.S. economy – these actions are long-overdue and monetary policy remains too loose. CPI inflation now stands at 8.6% per year but the Fed funds rate sits at only 1.6%. According to the Fed’s semiannual report, the rate should be over 6% under the Taylor rule. This disparity indicates not only the lengths the Fed has yet to go to normalize monetary policy, but also the fact that the Fed has largely boxed itself into a menu of purely reactive policy measures. Unless the Fed works quickly to move away from their discretion-based monetary policy approach that has remained consistently well-behind the curve, I am concerned the Fed will lose its credibility to effectively manage the national economic situation.”

Then, at 55 minutes into the hearing according to a recorded videotape, Senator Tillis said further that “By the Fed’s own analysis of various policy rules, including the Taylor Rule, the revised Taylor rule, the balanced approach rule, and the balanced approach short fall rule, rates should have begun to rise long before they did. According to the Fed’s own analysis of these rules, the fed funds rate should currently be above 6 percent; this is in the Report to Congress. Yet the rate currently stands at 1.6 percent. Likewise, the same rules could—should—have prompted the Fed to begin raising rates Q4 last year Q1 this year. I’m concerned that the Fed has opted out of rules-based to discretionary monetary policy. As the Fed reviews monetary policy strategy, Chair Powell, will you commit to considering an increased weight for rules based strategy for its decision making and if not why.”

Chair Powell answered: “We do use policy rules like the various forms of the Taylor rule in all of the analysis that we do.  If you are thinking about how monetary policy will affect the economy, you have to have some sort of a rule like that. The Fed has never really used them in a prominent way to actually set policy in real time. But that is not to say that they do not shed light. We do consult them on an ongoing basis. The rules all called for a deeply, deeply, negative rates during the pandemic, and we didn’t do that. They did call of course for rates to move up, and rates now really are moving up much closer to where the Taylor rule—various form of the Taylor rule—are.  And I think by the end of the year will be pretty close to where some of the Taylor rule iterations are.  It is something we consider. I think in a couple of years when we look at our framework again, that’s something we could look at.” 

Senator Tillis then responded: “Chair Powell could you just briefly explain the variance between rules-based decision making being at 6 and where we are today. What are the factors coming into play?”

Chair Powell answered: “Taylor rules don’t keep, they don’t take into consideration changes in financial conditions. They just look at the overnight policy rate. As I mentioned earlier, we began signaling, and we are set up now to signal policy changes going forward with the summary of economic projections that we do four times a year. So markets priced that in, and you are getting a lot of policy tightening well in advance of actually raising rates. As you pointed out we are 1.6 percent only on the federal funds rate, but look out the rate curve, all the…very substantial additional rate hikes are already priced in with financial conditions and they have been for several months. So that’s one way of thinking about it. It’s really only at the very short end of the curve where rates are still in negative territory from a real perspective. If you look farther out, real rates are positive right across the curve. That’s really what we are trying to achieve with policy. In a situation like this where we have forty year highs in inflation, and we know we need restrictive policy. And that is where we are headed.”

The press also covered the hearing. In an article called GOP to Powell: Play by the rules Kate Davidson of Politico wrote on June 23 and said that

“We expected Republicans to press Federal Reserve Chair Jerome Powell on the need to tighten policy faster at his Senate hearing Wednesday. But we were struck by how they used the occasion to revive an old GOP talking point: the Fed has too much discretion.”

“Sen. Thom Tillis (R-N.C.), who sat in as the ranking Republican at the session, argued that the Fed should be bound by formalized rules in its interest rate decisions, our Victoria Guida wrote. And he pointed to a formula, named after Stanford economist John Taylor, suggesting that the central bank’s main policy rate should be much, much higher than it is.” “The Fed has largely boxed itself into a menu of purely reactive policy measures,” Tillis said. “Unless the Fed works quickly to move away from their discretion-based monetary policy approach that has remained consistently well behind the curve, I am concerned the Fed will lose its credibility to effectively manage the national economic situation.

And in an article Assessing Monetary Policy Through The Taylor Rule by Blu Putnam, Chief Economist, CME Group, said : “In policy circles this trade-off is embodied in what is known as the Taylor Rule, which argues that the Fed should raise rates in line with a simple formula for an assumed inflation-jobs trade-off.… Of note, the Taylor Rule today, and for some time in the past, has been suggesting the Fed needs to start removing accommodation, which is what the Fed is now doing.”

And the discussion went global.  Here as an article about the Bank of England entitled Bank of England’s Interest Rate Should be Closer to 10% says Swiss Re written by Gary Howes “The most significant central bank tightening cycle in decades has begun and we expect much more policy tightening to come this year and next,” says Jérôme Haegeli, Swiss Re Group’s Chief Economist. “Approximations of an adequate interest rate policy, proxied by our estimates of the Taylor rule, suggest that almost all major advanced economy central banks are at least 2ppts below interest rate levels that would be warranted given the current economic environment,” says Haegeli. “The Taylor rule is an equation that prescribes the central bank policy rate as a function of inflation and economic slack such as the output gap or the unemployment gap.”

To conclude this post, the above is just a sampling of the commentary, and much of it is promising. Much has already been written over the years about monetary policy rules, which answers some of the points raised by Jay Powell. These issues will be covered and analyzed in future writings, as will the recent promising renewal of the focus on rules.

This entry was posted in Uncategorized. Bookmark the permalink.