IMPROVING MONETARY POLICY BY ADOPTING A SIMPLE RULE.

• Author: Orphanides, Athanasios
• Position: Essay

Monetary theory as well as monetary practice over the past few decades suggest that economic outcomes in our economy are better when monetary policy is systematic and respects the importance of maintaining price stability. (1) Despite broad agreement of the benefits of systematic policy, the Fed continues to set policy on a meeting-by-meeting discretionary basis. This article examines how policy can be improved by replacing discretion with a transparent process of selecting and periodically adapting a simple policy rule.

The Case for a Simple Rule

The Fed's decision to adopt a precise quantitative definition of price stability in January 2012 was an important step in the right direction. With the adoption of an inflation target--2 percent, measured by the PCE index--in its Statement on Longer-Run Goals and Monetary Policy Strategy (Federal Reserve Board 2012), the Fed can facilitate well-anchored inflation expectations in line with price stability and can be held accountable over time more easily.

However additional progress is required. The Fed's current policy framework places too much emphasis on meeting-by-meeting discretion and is not sufficiently systematic to be in line with best policy practice. This is particularly problematic because of the Fed's so-called dual mandate--to achieve simultaneously maximum employment and price stability.

It is well known that the mandate of the Federal Reserve can create difficulties for the institution when tightening policy is required to keep inflation at bay. The combination of meeting-by-meeting discretion and multiple conflicting goals makes the Fed vulnerable to all the pitfalls that monetary theory and history teach us are associated with the absence of systematic policy. This can be corrected if the Fed adopts and communicates a simple policy rule that it can then use as a guide for setting monetary policy. Adopting an appropriate simple rule would allow the Fed to respond in a countercyclical fashion to economic developments while protecting price stability over time. (2)

Countering Key Arguments against Rules

Unfortunately, the Fed has not shown the willingness to move in that direction and continues to prefer to operate with meeting-by-meeting discretion. In recent speeches, Fed Chair Yellen and Vice Chair Fischer have presented a case against monetary rules (Fischer 2017a, 2017b; Yellen 2017). It is instructive to examine the key arguments presented against rules and provide counterarguments to make progress in this policy debate.

Perhaps the most common argument against monetary rules is that discretion allows greater flexibility to take into account uncertainty. It is certainly important to acknowledge uncertainty. Policymakers face numerous dimensions of uncertainty. Our understanding of how the macro economy works is incomplete. Estimated macroeconomic models are imperfect, and often competing models with quite different policy implications may be equally plausible. Key concepts that would have been very useful for policy, if they could be measured accurately in real-time (e.g., the natural rate of interest), are in fact unknown.

The presence of uncertainty, however, cannot serve as a valid argument for defending discretionary policy. Indeed, uncertainty raises the potential costs of discretion as it makes it harder to understand how large a policy deviation may be from what would have been the desirable systematic response to a shock.

The reasons why systematic policy is preferable to discretion are no less important under uncertainty. Consider dynamic inconsistency, one of the major...