Monetary Policy: Rules vs. Discretion

Sound monetary policy is essential for strong economic growth and stability. It is often only noticeable when we get it wrong, as we have several times in recent history. In order to get it right, it helps to follow a rules-based policy instead of one based on discretion.

 

Monetary policy involves the control of the money supply – currency and deposits -- in the economy by our central bank, the Federal Reserve.

 

Perhaps the simplest way to think about how monetary policy works is through the “Federal Funds Rate” – that’s the interest rates that banks charge one another.

 

The Fed can change the federal funds rate by changing the money supply.

 

When the Federal Reserve is concerned that inflation is too high, it sets a higher federal funds rate. When the economy is weak or inflation is lower, it sets a lower rate to stimulate economic activity.

 

But how does the Federal Reserve know what the rate should be? That’s what a rules-based monetary policy is for. Under a rules-based policy, the Federal Reserve reacts to changes in the economy in a predictable manner.

 

An example is the “Taylor Rule”, which is a formula that central bankers use to adjust their interest rate according to changes in economic output and inflation. One feature, often called the Taylor Principle, is that if inflation rises, the central bank will raise the interest rate more than that increase in inflation.

 

Discretionary monetary policy, on the other hand, isn’t systematic or predictable. Central banks then succumb to political pressure and disrupt both firms’ and consumers’ decision making by acting differently than they previously indicated.

 

A rules-based system can still be flexible, because the interest rate isn’t fixed. But it allows businesses and families to make economic decisions with a reasonable amount of confidence.

 

By mapping out the Taylor Rule in modern American history, we can see what happens when the Federal Reserve deviates from a rules-based policy.

 

For example, the 1970s were marked by rapid inflation and high unemployment in part because the Federal Reserve ran a discretionary monetary policy. It kept interest rates too low in an effort to boost the economy, motivated by political pressure and the perception that raising the Federal Funds Rate would have a negative effect on growth.

 

But this discretionary policy had three bad outcomes: runaway inflation, more uncertainty for investors, consumers, and businesses, and weak economic growth.

 

That situation was resolved in the 1980s with the adoption of sound monetary policy by Federal Reserve chairs Paul Volker and Alan Greenspan. The period from 1983 to 2003, when the Federal Funds Rate closely followed the Taylor Rule, is often called the “Great Moderation.” It was marked by low inflation, low unemployment, mild recessions, and robust economic growth.

 

Unfortunately, monetary policy got off track in the years leading to the Great Recession of 2007 to 2009. With inflation picking up following the mild recession of 2000, the Federal Reserve should have started raising interest rates. Instead, it made a mistake by opting to keep rates too low for too long. This discretionary policy helped fuel a housing boom and subsequent bust, contributing to the harmful economic downturn.

 

While these deviations continued after the Great Recession and throughout the ensuing slow recovery, monetary policy appears to have gotten closer to a rules-based policy and the economy has improved.

 

When monetary policy has followed predictable, rules-based policies, we’ve seen long economic expansions, low inflation, and mild or infrequent recessions. When the monetary policy has moved away from such predictable policy, however, we’ve experienced rapid inflation, high unemployment, and severe recessions.