It’s Time to Reexamine Monetary Policy Rules

A fter last month’s Federal Open Market Committee meeting, Fed watchers remain busy parsing every word uttered that day by the new Fed Chair Kevin Warsh. One clear takeaway from the meeting is that Warsh intends future such gatherings to yield far fewer words to parse as “forward guidance” likely becomes a thing of the past.

Rightly so. The practice of having multiple Fed officials give multiple Polymarket-like interest rate predictions through multiple speeches and dot plots has yielded more confusion than credible guidance.

It’s a good first step, but given that the Fed has missed its inflation targets for five years running and consumers are still reeling from the worst inflation in 40 years, Warsh clearly knows that forward guidance is not the only Fed practice in need of reform. As he has now launched multiple task forces, he should direct one of them to revisit the idea of adopting a monetary policy rule.

This reform alone could provide greater predictability to financial markets, better results for the economy, and help strengthen monetary policy independence during a time of challenge. Despite its name, adopting a monetary policy rule does not mean putting monetary policy on autopilot and simply walking away. It means anchoring monetary policy to a well-defined strategy that is systematic and, save for unique circumstances, is applied to changes in incoming economic data. It holds, in other words, if “X” occurs, the public can normally count on the Fed to do “Y.”

What a monetary policy rule doesn’t represent is the status quo. It is not, as is current practice, purely discretionary, often improvisational, principally projection-driven, and largely indiscernible to the American public. Although the debate over the use of monetary policy rules is not a new one, with a new reform-minded Fed chair, it will hopefully once again become a relevant one.

Milton Friedman, the most renowned monetary policy economist of our time, was an early advocate of policy rules, as have been other Nobel Laureates in economics, including the 2004 winners, Finn Kydland and Edward Prescott. Undoubtedly the best-known proponent of monetary policy rules remains John Taylor of Stanford University, who developed the eponymous Taylor Rule and who, incidentally, was interviewed for the chairmanship of the Fed by President Donald Trump during his first term.

Taylor published research demonstrating that between 1982 and 2003, during what is known as the Great Moderation, the Fed generally followed the specific reaction function recommended by his rule, which sets a target Fed funds rate based upon inflation, the assumed neutral interest rate, and the gap between actual GDP and potential GDP. During these years, Consumer Price Index (CPI) inflation was consistently kept between 2 and 3 percent, inflation expectations were well anchored, the economy experienced only two mild recessions, and the standard deviation of quarterly GDP growth fell by roughly half from the previous decade.

In contrast, the Fed followed no discernible policy rule during the 1970s up until the Volcker era. During these years, CPI inflation averaged roughly 7.5 percent, peaked at 13.5 percent in 1980, and the misery index was off the charts. In the lead-up to the 2008 Great Financial Crisis, the Fed likely contributed to the housing bubble by setting rates between 1 and 2 percent in 2003 and 2004 when, in contrast, the Taylor Rule would have prescribed much higher rates of 3 to 5 percent.

Few disagree that the Fed took necessary emergency actions in March 2020 at the outset of the Covid-19 pandemic. Unfortunately, the Fed kept its funds rate at 0.0 to 0.25 percent long after growth rebounded strongly, labor markets tightened significantly, and inflation rose sharply. Even the Fed itself has reported that several benchmark rules, including Taylor’s, would have set rates far above where it actually set them in late 2021 and early 2022. The gap was never greater and the deviation never costlier.

Critics of monetary policy rules rightfully argue that rules can never be followed robotically since they cannot account for every exogenous event, such as supply shocks. Rules advocates readily agree there will always be exceptions. Parenthetically, given the experience of the pandemic, it appears that current Fed models are not particularly good at accounting for supply shocks, either.

Critics further maintain that rules rely too much upon estimates of unknown factors, such as potential output, economic slack, and the neutral interest rate. Yet the Fed’s own flagship model is estimated to rely upon more than 350 variables and between 300 and 400 equations. Although the Fed prides itself on being data-dependent, we still don’t know precisely which data the Fed uses and how that data is weighed, much less how the reaction function responds to that data.

Another compelling reason for the Fed to adopt a policy rule is to preserve its own independence, though Fed independence should not be equated with unfettered discretion. Instead, independence should be understood to mean that monetary policy will be conducted free of partisan political agendas, be they foisted by the White House or progressive DEI and Environmental, Social, and Governance (ESG) advocates. A policy rule can serve as both a guardrail for congressional accountability and a protective wall, allowing the Fed to defend the solid ground of stated policy, consistently applied.

There are several serviceable policy rules beyond the Taylor Rule, although most are variants of it. What they have in common is that they are both systematic and predictable. After careful study, the Fed should publicly adopt a policy rule of its own choosing, and should it later decide to either temporarily deviate from it or change it altogether, it should then publicly explain why. A policy rule followed even 80 percent of the time is likely to yield better results than pure unpredictable discretion exercised 100 percent of the time.

Warsh has made it clear that the Fed needs to reform its frameworks, and in his confirmation hearing, he argued that “inflation is the Fed’s choice.” Adopting the right policy rule would be a good way for the Fed to quit choosing it.