Legislating a rule for monetary policy.

• Author: Taylor, John B.

In these remarks I discuss a proposal to legislate a rule for monetary policy. The proposal modernizes laws first passed in the late 1970s, but largely discarded in 2000.

A number of years ago I proposed a simple rule as a guideline for monetary policy. (1) I made no suggestion then that the rule should be written into law, or even that it be used to monitor policy, or hold central banks accountable. The objective was to help central bankers make their interest rate decisions in a less discretionary and more rule-like manner, and thereby achieve the goal of price stability and economic stability. The rule incorporated what we learned from research on optimal design of monetary rules in the years before.

In the years since then we have learned much more. We learned that such simple rules are robust to widely different views about how monetary policy works (see Taylor and Williams 2011). We learned that such rules are frequently used by financial market analysts in their assessment of policy and by policymakers in their own deliberations (see Asso, Kahn, and Leeson 2007). We learned that when policy is close to such rules, economic performance is good: inflation is low, expansions are long, unemployment is low, and recessions are short, shallow, and infrequent; but when policy is short-term focused and deviates from such rules, economic performance is poor (see Meltzer 2009).

Why legislate a policy rule now? Because monetary policy has recently become more discretionary, more short-term focused, much less rule-like than it was in the 1980s and 1990s, and economic performance has deteriorated. A legislated rule can reverse the short-term focus of policy and restore credibility in sound monetary principles consistent with long-term price stability and strong economic growth.

Signs of a shift toward more discretion appeared as far back as 2002-04, when the policy interest rate was held below settings that worked well during the 1980s and 1990s. But policymakers have doubled down on discretion since then. When the bursting housing bubble led to tensions in the financial markets in 2007, policymakers used the central bank's balance sheet to finance an ad hoe and chaotic series of bailouts which led to the panic in the fall of 2008. After helping to arrest the panic, they then further expanded the balance sheet in order to finance massive purchases of mortgage-backed and Treasury securities (the first tranche of so-called quantitative easing, or QE1). And now they have embarked on yet another program of large-scale purchases (QE2), which increases risks about inflation down the road or further disruptions when the balance sheet is sealed back. A legislated rule would increase certainty that the size of the balance sheet will be reduced in a timely and predictable manner and thereby reduce this risk.

My research shows that these discretionary actions were, on balance, harmful. But even if one disagrees, the actions should raise concerns about a monetary system in which a great deal of power is vested in an organization with little accountability and without checks and balances. The purchase of mortgage-backed securities explicitly shifts funds to one sector and away from others, an action which should be approved by Congress. Putting taxpayer funds at risk is a credit subsidy, which should be appropriated by Congress. Some of the discretionary actions are inconsistent with the intent of the Constitution because they take monetary policy into fiscal or credit allocation areas and thereby circumvent the appropriations process. The recent QE2 action irritated many countries around the world, and may have impacted U.S. foreign policy by affecting the ability of the United States to negotiate positions at the recent G20 meeting.

In sum, these recent discretionary actions, combined with the success of a more strategic rule-like policy in the decades before, raise the question of legislating rules for monetary policy.

While passing such legislation necessarily involves the president and the Congress of the United States, it does not mean that the president or Congress should insert themselves in the operational decisionmaking process of the Federal Reserve. Indeed, legislation in the 1970s, which I...