Jeb Hensarling (R-TX), chairman of the House Financial Services Committee, launched the “Federal Reserve Centennial Oversight Project” this year in conjunction with the Fed’s 100th anniversary. As part of that project, Committee members Scott Garrett (R-NJ) and Bill Huizenga (R-MI) have introduced the “Federal Reserve Accountability and Transparency Act” (H.R. 5018) designed to rein in the Fed’s discretionary power and reduce policy uncertainty by having the Fed adopt a rules‐based approach to monetary policy. As Hensarling notes, “Monetary policy is at its best in maintaining stable, healthy economic growth when it follows a clear, predictable rule or path.”
The central feature of the proposed legislation is to require the Federal Open Market Committee to clearly state and adopt a monetary rule in place of its current purely discretionary stance. The Fed would have a choice among alternative rules but would be required to use the popular Taylor Rule (named after John Taylor, a long‐time professor of economics at Stanford University) as its reference point.
That rule would require forecasting potential output, selecting an inflation target (now 2 percent), and making an assumption about the “natural rate of interest” (the equilibrium real fed funds rate). The Taylor Rule currently implies that the near‐zero fed funds rate is too low and should be increased. In the absence of an output gap and with inflation at the Fed’s target rate, the Taylor Rule would yield a nominal funds rate of 4 percent, which would be consistent with 2 percent inflation and a real rate of 2 percent. Today real rates are negative.
By using the Taylor Rule as the baseline, H.R. 5018 is implicitly constraining the Fed to an interest‐rate target. If the Fed deviates from the Taylor Rule, it would have to explain why and would be audited by the General Accountability Office. Nevertheless, the Fed would still have a large amount of discretion, and no one would be held liable for departing from the adopted rule — whatever it is. Current law regarding the dual mandate (price stability and maximum employment) would continue, although separate legislation has been proposed to end that mandate and adopt long‐run price stability as the primary objective of monetary policy.
There are many rules the Fed could choose from, including a simple money growth rule, a price level rule, an inflation target, and a nominal demand rule, in addition to the Taylor Rule. Those rules have all been debated thoroughly in the vast literature discussing rules versus discretion in the conduct of monetary policy.
Fed Chairwoman Janet Yellen dislikes the idea that the Fed would be subject to a rule, even of its own choosing. Financial crises require judgment and a rigid rule may prevent necessary adjustments, she argues. But there are limits to what monetary policy can accomplish, and discretion may instead lead to policies that initiate and accentuate business fluctuations. In her recent testimony before the House Financial Services Committee, Yellen argued, “It would be a grave mistake for the Fed to commit to conduct monetary policy according to a mathematical rule.”
In testimony before the Senate Banking Committee, Yellen offered her case for discretion: “The reason we have low interest rates is to deal with a very real problem, namely, the economy is operating significantly short of its potential.” In her judgment, the output gap is large and calls for an activist Fed policy. But the Fed’s own forecasting models failed to predict the Great Recession and continue to be a poor guide to the future path of the real economy.
It is well known that sustained monetary stimulus does not generate real economic growth or reduce unemployment; the stagflation of the 1970s should have ended any romance with the notion of a tradeoff between inflation and unemployment. Likewise, real income growth is consistent with gently falling prices (deflation) if output grows faster than the money supply, as happened during the classical gold standard.
To think that ultra‐low interest rates and QE are the cure for unemployment and slow growth is a delusion. Over‐regulation, high taxes on capital, massive government spending, enormous policy uncertainty, and crippling unfunded liabilities in entitlement programs need to be addressed as part of the effort to renew U.S. growth and create jobs.
The Fed has acted as a fiscal agent for the bloated federal government, keeping rates low to finance runaway spending. It has also engaged in credit policy by buying up mortgage‐backed securities in three rounds of QE. During this exercise in “fine‐tuning,” the Fed’s balance sheet has grown from less than $1 trillion to more than $4 trillion. Exiting its unconventional policies is sure to be disruptive; the more so the longer it is delayed.
By keeping interest rates artificially low for an extended period, the Fed has encouraged risk taking, fueled asset prices, and greatly increased the probability of another boom‐bust episode. Asset values have far outpaced real income growth in the last several years; a situation that is untenable in the long run. Moreover, real interest rates cannot be held in negative territory without severe damage to the allocation of capital, and must be corrected at some point.