Ever since the U.S. severed the last remnant of the dollar’s link to gold in 1971, economists have been searching for a new rule for monetary policy. The Great Inflation of the 1970s only reinforced the notion that rules trump discretion. But what sort of rule exactly?
Milton Friedman wanted to replace the Federal Reserve with a computer that would increase the stock of money by a fixed amount, month in, month out. Paul Volcker, who was appointed Fed chairman in 1979, introduced a money-supply target. The target he chose -- “non-borrowed reserves” -- has no relationship to anything the Fed cares about, be it inflation, employment or output. That said, it provided the cover to push the fed funds rate as high as 20 percent without actually specifying an interest-rate target.
In 1992, Stanford University economist John Taylor devised a rule that bears his name: a formula for determining the appropriate level for the overnight rate based on the gap between actual and target inflation and between actual and potential output. Although the Fed didn’t explicitly follow the Taylor Rule, many observers have said it captures how the Fed behaved under Alan Greenspan. Once the funds rate hit zero, the Taylor Rule provides a theoretical level for where it should be.
Many emerging Asian economies, including China and Hong Kong, chose an exchange-rate rule. They pegged their currencies to the U.S. dollar, effectively hitching their domestic monetary policy to the Fed. The decline in the dollar over the last decade forced them to sell their own currencies, which created inflationary pressures and, in China’s case, goosed a property bubble.
For other central banks, adopting an inflation target -- or more correctly, a medium-term range for inflation -- was the answer. The Reserve Bank of New Zealand became the first to adopt a formal inflation target in 1990 under a law that held the central bank’s governor accountable for failing to hit it.
For a while, it seemed as if central banks had found the path to enlightenment. In the U.S., the period from about 1983 to 2007 became known as the Great Moderation. Inflation was low and stable, and growth was strong. Ben Bernanke, who came to the Fed initially as a governor in 2002, was an advocate of inflation targeting. He even wrote a book on it. He often said that low inflation was both an end in itself and a means to full employment.
When Bernanke returned as Fed chairman in 2006, he tucked the book into his night table while he dealt with a financial crisis, a deep recession, an insolvent banking system and high unemployment. Low inflation, it seems, was a necessary but not a sufficient condition for a sound economy. (House prices aren’t even captured in traditional inflation measures, which use the imputed rental value.)
Yes, the Fed finally made its implicit 2 percent inflation target explicit in January 2012. But policy makers have been more explicit about the need to reduce unemployment, even if it means a modest overshoot on inflation. Setting a 6.5 percent unemployment rate threshold for contemplating a funds rate increase hardly qualifies as a rule. What it is, is a case-by-case study.
Think how much simpler it would be to adopt a nominal GDP target, which encompasses real GDP plus inflation. That’s what the Fed cares about. It even incorporates the Fed’s dual mandate of stable prices and full employment. (The road to full employment goes through strong growth.) It’s a lot better than the current mishmash of a threshold for unemployment, an inflation forecast (the Fed’s), and a market-based indicator of inflation expectations.
A nominal GDP target might not have prevented the housing bubble, but it would have mitigated the fallout from the collapse, according to market monetarists, a group of economists who advocate an NGDP target. If the Fed had made it clear it would keep nominal income on a steady path -- if it had applied “whatever it takes” to an explicit goal -- it could have gotten a bigger bang for its buck, or a higher turnover rate (velocity) for each dollar of quantitative easing, according to Scott Sumner, a professor of economics at Bentley University in Waltham, Massachusetts.
“With more effective monetary policy, the Fed could do less,” Sumner said during a panel discussion March 22 at the American Enterprise Institute in Washington.
No rule is perfect or can replace the gold standard of rules, which happens to be the gold standard, with its convertibility of a dollar into gold at a fixed price. Still, with the Fed’s balance sheet at $3.2 trillion and counting, and unwinding those purchases as the next hurdle, policy makers might find themselves wishing they had heeded Sumner’s claim that less is more.
(Caroline Baum, author of “Just What I Said,” is a Bloomberg View columnist. The opinions expressed are her own.)
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