SHOULD THE FED BE CONSTRAINED?

• Author: Frankel, Jeffrey

To what extent should the central bank be constrained, rather than allowed full discretion in setting monetary policy? Should the constraint be legislated rules telling the monetary authorities to target a nominal variable like the price of gold, M1, or the inflation rate? Or some sort of Taylor Rule that requires it to set interest rates according to a formula? Even if the Fed continues to retain its cherished independence from the rest of the government, should it constrain itself by adopting inflation targeting or a Taylor rule?

Even forward guidance constitutes a form of self-constraint, though admittedly of a weaker sort. Some make a distinction between "Odyssean guidance," in which the central bank intends to "tie its hands" in the interest of moving expectations, versus "Delphic guidance" that aims only to reveal its honest forecast in the interest of transparency (Campbell et al. 2012). But in either case, if the economy evolves in a way that was not anticipated, the ex ante pronouncement may act ex post as a constraint on policy decisions in ways that intervening events have rendered unwelcome.

I am increasingly convinced that the constraint must be very loose. Central bankers chronically end up unable to fulfill commitments to nominal targets, rules, or even their own forward guidance. The reason, in most cases, is not that they are insincere, but rather that unforeseen shocks come along after the policy is set. These shocks can make it highly undesirable to stick with the target or, in some cases, can make it impossible.

Satisfying Constraints Is Harder than It Sounds

Consider a selection of possible examples, out of many, where central banks were unable to fulfill commitments. Start with nominal targets, such as fixing the price of gold, the exchange rate, the money growth rate, or the inflation rate.

When Milton Friedman (1948) argued for rules over discretion, the rule that he had in mind was a fixed rate of growth of the money supply. He temporarily won the debate in 1980. But the Fed was forced to abandon its experiment with monetarism in 1982, because of a big increase in the demand for money. Velocity shocks render money targets unworkable.

To take an example from abroad, the Bundesbank continued to pay lip service to M1 targets until the end of its life, but usually missed its targets. The same is true of other countries today that still cite the money supply when the IMF requires them to declare their nominal anchor. Late in his life Friedman admitted that he had overestimated the stability of the money demand function.

Consider, second, inflation targeting (IT) (e.g., Svensson 1999). Inflation targeters also chronically miss their targets. Traditionally they would miss on the upside, failing to bring inflation down as much as promised. But since the 2008 crisis, advanced countries have missed their targets on the downside, failing to bring inflation up as much as promised. The United States undershot its inflation target for 10 years following the Great Recession, despite quadrupling the monetary base and--eventually--reattaining full employment. Japan made an all-out commitment in 2013 to raising its inflation rate to 2 percent. This was the centerpiece of Abenomics, the platform on which the new government had come to office. Yet five years later, Japan still hasn't even achieved 1 percent inflation.

Price level targeting has been proposed as an alternative to inflation targeting, but would be even less credible. It is true that in a deflationary episode such as 2008-09, a price level target cleverly gets expectations working in a more powerful way, if one assumes that the targets are believed. (The price level target requires that the central bank makes up for misses, while an inflation target lets bygones be bygones.) But why should the public believe such a target?

The same is true for proposals to set an inflation target of 4 percent rather than 2 percent (Blanchard, Dell'Ariccia, and Mauro 2010). Following a period when central banks have been unable to achieve modest targets like 2 percent inflation, why should the public find the proclamation of a more aggressive target credible?

One is reminded of a diet plan that targets losing 1 pound the first...