Inflation shows both the value and limits of monetary-policy rules

It was a curious omission. In February, when the Federal Reserve published the winter edition of its semi-annual report to Congress, it dropped a normal section outlining the appropriate level of interest rates as determined by “monetary-policy rules”. Its inclusion might have been awkward, because it would have suggested that rates should be as high as 9%, when the Fed still had them near to 0%. In subsequent hearings at least three members of Congress pressed Jerome Powell, the Fed’s chairman, to explain its absence. Mr Powell promised that the section would be back in its next report. And so it was when the summer edition was published on June 17th—though only after the Fed had started to catch up to the rules’ prescriptions by rapidly raising rates.

As controversies go, the disappearance of a three-page section in a lengthy policy report was rather minor. It garnered scant media coverage. Nevertheless, it was important. It shone light on a decades-old question that is being asked with more insistence amid soaring inflation: should central banks limit their discretion and set interest rates according to black-and-white rules?

The search for rules to guide and constrain central banks has a long pedigree. It dates back to the 1930s when Henry Simons, an American economist, argued that authorities should aim to maintain “the constancy” of a predetermined price index—a novel idea in his era. In the 1960s Milton Friedman called for central banks to increase the money supply by a set amount every year. That monetarist rule was influential until the 1980s, when the relationship between money supply and gdp broke down.

Any discussion of rules today conjures up a seminal paper written in 1993 by John Taylor, an economist at Stanford University. In it he presented a straightforward equation which came to be known as the “Taylor rule”. The only variables were the pace of inflation and the deviation of gdp growth from its trend path. Plugging these in produced a recommended policy-rate path which, over the late 1980s and early 1990s, was almost identical to the actual federal-funds rate, the overnight lending rate targeted by the Fed. So it seemed to have great explanatory power. Mr Taylor argued that his rule might help to steer central banks on the right path for rates in the future.

However, just as the Taylor rule started to get attention from economists and investors alike, its explanatory power grew weaker. In the late 1990s the recommended Taylor rate was consistently lower than the fed-funds rate. That sparked a cottage industry of academic research into alternative rules, mostly grounded by Mr Taylor’s original insights. Some put more weight on the gdp gap. Others added inertia, since central banks take time to adjust rates. Another group shifted from current inflation to forecasts, trying to account for the lag between policy actions and economic outcomes. In its reports the Fed usually mentions five separate rules.

The appeal of rules lies in their cold neutrality: they are swayed only by numbers, not by fallible judgment about the economy. Central bankers love saying that their policy decisions are dependent on data. In practice they sometimes struggle to listen to the data when their message is unpalatable, as it has been with inflation for the past year. Central bankers found numerous reasons, from the supposedly transitory nature of inflation to the limited recovery in the labour market, to delay raising rates. But throughout that time, the suite of rules cited by the Fed was unambiguous in its verdict: tightening was needed.

The rules are, however, not perfectly neutral. Someone first has to construct them, deciding which elements to include and what weights to ascribe to them. Nor are they as tidy as implied by the convention of calling them “simple monetary-policy rules”. They are simple in the sense that they contain relatively few inputs. But just as a bunch of simple threads can make for one messy knot, so a proliferation of simple rules has made for a baffling array of possibilities. For example, the Cleveland Fed publishes a quarterly report based on a set of seven rules. Its most recent report indicated that interest rates should be anywhere between 0.6% (per a rule focused on inflation forecasts) and 8.7% (per the original Taylor rule)—an uncomfortably wide range.

Moreover, each rule is built on top of a foundation of assumptions. These typically include estimates of the long-term unemployment rate and of the natural interest rate (the theoretical rate that supports maximum output for an economy without stoking inflation). Modellers must also settle on which of a range of inflation gauges to use. Slight changes in any of these inputs—common during periods of economic flux—can produce big swings in the rates prescribed by the rules. For example, an adjusted version of the Taylor rule, based on core inflation, would have recommended an interest-rate increase of a whopping 22 percentage points over the past two years (starting from negative 15%). Slavishly following such guidance would make for extreme volatility.

Average elegance

One possible solution is to combine multiple rules into a single result. The Cleveland Fed does just this, constructing a basic median out of the seven rules it tracks. Using this as a reference point, Mr Powell and his colleagues ought to have started raising rates gingerly in the first quarter of 2021 and should have brought them to roughly 4% today, more than twice as high as they actually are. That is much more sensible as a recommendation than the conclusion yielded by any single policy rule.

Such a median could never substitute for analysis of a range of data by central banks. But there is a big difference between taking rules seriously and treating them as holy writ. After all the inflation missteps of the past year, a healthy sample of rules deserves a closer look in policy debates. And they certainly deserve more prominence than they currently get as a short section in monetary reports that the Fed can choose to omit when inconvenient. ■

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Read more from Free Exchange, our column on economics:
Are central banks in emerging markets now less of a slave to the Fed? (Jul 9th)
The case for strong and silent central banks (Jun 30th)
People’s inflation expectations are rising—and will be hard to bring down (Jun 19th)