Reforming the Federal Reserve, Part 2: Enforcing Rules-Based Monetary Policy

Still, poorly executed monetary policy can have severe consequences, and the government’s poor record of monetary stewardship is sufficient cause for reforming the Fed. Importantly, as long as the fiat US dollar remains the base money for the American economy, then a government entity will have ultimate control over the supply of the economy’s base money. Still, there is scope to keep the Fed from worsening economic conditions, even if it cannot provide a salve to every economic ailment. To this end, monetary policy should be clear, concise, predictable, and as immune from political pressure as possible. All these traits are best achieved by eliminating much of the Fed’s discretionary authority and requiring it to set its interest rate target using a policy rule.

When considering the tools the Fed has at its disposal, it is unreasonable to expect the Fed to achieve precise economic outcomes. For most of the history of monetary policy, the Fed’s main tool was buying or selling government securities to increase or decrease the monetary base. It conducted these operations to influence the federal funds rate (FFR)—the interest rate at which banks borrow overnight reserves from each other in the private market—toward a predetermined target. Since the FFR represents the cost at which banks can acquire money to fund their operations, the FFR affected the various rates at which banks were willing to give loans to their customers.

During the 2008 financial crisis, the Fed dramatically changed its operating framework by flooding the banking sector with reserves. Though the Fed often talked of reverting monetary policy to the previous system, this framework has remained in place since the crisis. Whereas the old framework could be characterized as a “scarce reserve” framework, the new framework is referred to as one with “abundant reserves.” From 1984 through 2007, the weekly aggregate balance averaged $19 billion. By the end of 2009, however, this total exceeded $1 trillion. Though the amount has fluctuated, it is currently over $3 trillion.

In this type of abundant reserve framework, changing the quantity of these reserves no longer affects the FFR. Instead, the Fed now alters the FFR by paying banks interest on reserves (IOR).¹ Banks will not lend to other banks at rates lower than the risk-free rate at which they can collect interest from the Fed. Consequently, changing the IOR rate to affect the cost of holding reserves is now the Fed’s main instrument for changing the FFR and thereby conducting monetary policy.²

This explanation describes the theory behind how monetary policy is supposed to work, but even when the Fed buys securities or lowers the IOR rate to lower the FFR, private banks still need to issue loans to produce increased economic activity. Likewise, if the Fed sells securities or increases the IOR rate to increase the FFR, private banks have to decrease their lending to slow economic activity. In either instance, there is no guarantee that the Fed’s operations will lead to a precise change in lending that will, in turn, lead to a precise change in the broader money supply, interest rates, prices, unemployment, or overall economic activity.³

While changes in the money supply do not affect the “real” level of economic activity in the long run, they can still affect real outcomes in the short run.⁴ Consequently, many economists have long sought ways to use monetary policy to minimize short-run economic disruptions (often called business cycles). Of course, the main tool the Fed uses to minimize these economic disruptions is influencing short-term credit markets, as explained in the preceding section.

For decades, many economists have argued for monetary policy rules to help minimize short-run economic disruptions. For instance, some have argued that the monetary base should be frozen, with private banks creating currencies to fill the demand for money.⁵ Others have called for constant growth of the monetary base at a given percentage each year.⁶ Most modern macroeconomists advocate for rules that directly determine the target for the FFR rather than rules that govern the growth of the money supply. These rules generally update the target rate in response to current values of macro indicators such as inflation, unemployment, or output growth.⁷

Many central bankers argue that these kinds of monetary policy rules are too restrictive and that they would prevent the Fed from enacting the appropriate monetary policy response to economic changes. Instead, because of the enormous complexity of the economy and its ever-changing nature, they advocate for maintaining a high level of discretion for the Fed to implement monetary policy as it sees fit. But the complex nature of the economy makes the case for rules-based policy even stronger. Since no one person (or small group of central bankers) can be expected to understand and react properly or consistently to changing economic conditions, policy rules would reduce uncertainty among citizens and firms by making the Fed more predictable and transparent.

Committing to a rule would prevent the Fed from raising or lowering its target rate due to political pressure and, therefore, better insulate its policy independence. Rules also help the Fed with forward guidance, allowing the public to more accurately anticipate how the Fed would respond to economic conditions in any future state of the world.⁸

Congress should require the Fed to adopt a rules-based monetary policy to reduce uncertainty by anchoring people’s expectations regarding what the Fed will do on a continuous basis.

Monetary policy rules were first devised because they are robust to changes in or misperceptions of the underlying structure of the US economy. Even if policy rules do not consistently lead to optimal outcomes, they are preferable to how monetary policy is conducted currently because they never leave the public guessing what the Fed will do next, thus allowing people to more easily adjust their behavior to changing economic conditions. In the absence of rules, the Fed’s discretionary policy choices have failed to prevent short-run fluctuations, as was clear with the post-pandemic inflation surge. When central bankers are wrong about the nature of economic relationships, as they were after the pandemic when they labeled inflation “transitory,” policy rules offer a superior choice to discretion.⁹

There is some disagreement over which policy rule is the best one. However, many of the standard policy rules are mathematically similar, and they are designed to respond to short-term shocks that move the economy away from its long-term equilibrium path. As other research from Cato’s Center for Monetary and Financial Alternatives has shown, debates among experts over the superiority of various rules should not hamper the Fed’s immediate commitment to following a rule.¹⁰ Every rule offers a trade-off between potential short-run stabilization benefits and the informational burden it places on the Fed.¹¹ In general, rules that target inflation, unemployment, and output growth offer better stabilization but suffer from higher information burdens. Even simple inflation targeting is a feasible choice; while research suggests it would be less stabilizing than the other rules, its simplicity drastically reduces the Fed’s informational burden, ensuring that the Fed relies only on its most forecastable variable—inflation.

Since no one rule is plainly best and most rules under consideration are better than discretion, the Fed should decide which of the various trade-offs are most desirable and credibly commit to following the rule associated with those desirable traits. Maximizing predictability and transparency is likely the best that can be achieved given the current monetary framework. To ensure that the Fed and elected officials remain accountable for monetary policy decisions, Congress should require the Fed to adopt rules-based monetary policy.

As we have argued, rules are superior to discretion, and disagreements over which specific rule the Fed should follow are not so important as to prevent the Fed from following a rule in the first place. Naturally, it is also important to discuss how such a system would be implemented. A template for implementing this system already exists—the Fed Oversight Reform and Modernization (FORM) Act of 2015.¹² Under legislation such as the FORM Act, the Fed would be required to specify and follow a rule when setting its interest rate target. The choice of which rule would be up to the Fed (or more specifically, to the Federal Open Market Committee), and the rule would be binding only in that once the Fed picked a rule, it would have to follow it unless it explained its deviations from the rule to Congress. Ideally, such a rule should have academic rigor and be clearly specified, unlike the Fed’s adoption of flexible average inflation targeting in 2020.¹³ The Fed could update the rule at regular intervals, such as at its five-year framework review. Additionally, at each such rule review, the Fed should also update and clarify its target for the inflation rate. It should not always target 2 percent inflation, as the optimal inflation rate can vary with economic conditions, such as long-term productivity changes. The target rate should be chosen with increased academic rigor and within a proper structural framework.

Though many central bankers will likely disagree, such a system would not hamstring the Fed. The Fed could, for instance, update the rule to account for structural changes to the US economy. Additionally, it is possible for exigent circumstances to arise that require an immediate deviation from the rule. An example would be the sudden shutdown of an otherwise healthy economy during the COVID-19 pandemic. Under such unforeseen circumstances, this kind of rules-based policy would allow the Fed to deviate from the stated rule, provided it explains its reasoning publicly to Congress. If the public were to disagree with the Fed’s reasoning, it could hold the Fed accountable through its elected representatives more easily than now. Under the current system, it is often difficult to ascertain the exact reasoning behind the Fed’s policy moves despite some increases in transparency, such as more-detailed statements from the Federal Open Market Committee and the Fed chairman holding press conferences following policy rate decisions.

The Federal Reserve Act requires the Fed to promote price stability and low unemployment, but it places no binding requirements on how the Fed achieves that mandate. Providing the Fed with this level of discretion has made monetary policy more ambiguous and unpredictable than it should be and has left the Fed exposed to too much political pressure. Congress can rectify these problems by requiring the Fed to follow a monetary policy rule.

The exact choice of rule is important, but most popular rules mirror the recommendations of the others—and all of them outperform Fed discretion. Thus, disagreement over the superiority of a single rule should not prevent Congress from requiring the Fed to follow a monetary policy rule. Congress can improve monetary policy outcomes by imposing a rules-based regime on the Fed, and the framework envisioned in the 2015 FORM Act would do so while providing the Fed with sufficient flexibility to operate when unforeseen events arise.