Fighting the Fed

The Reference Policy Rule is essentially the rule by John Taylor of Stanford University, based on his statistical estimate of what the Fed appeared to have been doing under Paul Volcker and Alan Greenspan during a period of both low inflation and low unemployment. It states that the federal funds rate should be 2% plus the current inflation rate plus one-half of the difference between current and target inflation and one-half of the percentage difference between current and full-employment GDP.

All of this implies that if the economy is at full employment and targeted inflation, the federal funds rate should equal 2% plus the rate of inflation. It should be higher if the inflation rate is above the target level and lower if current GDP is less than the full-employment level.

Given uncertainty about the level of full-employment GDP, this rule still leaves the Fed substantial discretion. The Fed could argue that the gap between current and full-employment GDP is larger than the 6.1% unemployment rate implies, owing to the large number of part-time workers who would prefer full-time employment and the sharp decline in the labor force participation rate. If the GDP gap is 4%, as a implied, the Taylor rule would indicate an optimal federal funds rate of about 1.25% (2 + 1.5 – 0.25 – 2), compared to the current rate of only 0.1%.

While the federal funds rate may be heading to 1% over the next 12 or 18 months, by then the narrowing GDP gap will imply an even higher Taylor-rule interest rate. And, complicating things further, given US banks’ vast holdings of excess reserves as a result of the Fed’s bond-buying policies (quantitative easing), the federal funds rate is no longer the key policy rate that it once was. Instead, the Fed will be focusing on the interest rate on excess reserves.

The proposed legislation is full of excessive and impossible requirements, and the Republican-controlled House of Representatives may not be able to pass it, even in modified form. Even if it does, it will not get through the Democratic-controlled Senate. But if the Republicans hold a Senate majority after the next election, some form of legislation requiring a monetary-policy rule could land on the president’s desk. He or she might veto it, but a Republican president after the 2016 election might not.

The Fed no doubt fears that if the principle of requiring a formal rule is accepted, Congress could tighten the requirement, forcing a more restrictive monetary policy. That is why the new Fed chair, Janet Yellen, forcefully opposed such legislation in .

One thing is certain: The bill will put pressure on the Fed to pay more attention to inflation, avoiding a persistent rate above its own 2% target. Otherwise, the Fed’s operational independence could be restricted, forcing it to focus its policies more sharply on its inflation mandate.

Martin Feldstein, Professor of Economics at Harvard University and President Emeritus of the National Bureau of Economic Research, chaired President Ronald Reagan’s Council of Economic Advisers from 1982 to 1984.

Copyright: Project Syndicate, 2014.