Speaking at last month’s economic policy symposium in Jackson Hole, Wyoming, Federal Reserve Chair Jerome Powell described vividly the challenges that central bankers face in a world of constant change and uncertainty. These challenges make it impossible for the Fed to perfectly fine-tune the economy. Chair Powell’s preferred, gradual approach to raising interest rates is therefore justified. The Fed could meet these challenges even more effectively, however, by adopting and following a monetary policy rule.
In his remarks at Jackson Hole, Chair Powell drew special attention to the “shifting stars,” meaning the time-varying natural rates of interest (“r-star”) and unemployment (“u-star”) expected to prevail in the long run, that is, when the economy is experiencing normal growth instead of boom or recession. In a static world without uncertainty, the Fed could easily judge whether its policy is too loose or too tight by comparing its target for the federal funds rate to the natural rate. By holding the funds rate below r-star, the Fed causes monetary policy to be expansionary, pushing unemployment below its natural rate and allowing inflationary pressures to build. And by raising the funds rate above r-star, the Fed makes policy contractionary: unemployment also rises above u-star and disinflationary forces take hold.
Chair Powell’s natural-rate framework highlights that the Fed’s ability to stabilize inflation in the long run depends on its ability to track, with its funds rate target, underlying trends in the natural rate of interest. This is why the Fed needs to continue raising interest rates: not to choke off the economic expansion, but to maintain an environment of stable prices within which economic growth can persist.
If r-star and u-star were constant and known, then the Fed would have no trouble fine-tuning the economy in the short run as well. Alas, neither of these natural-rate variables stays constant for long and, as Chair Powell’s review of monetary history makes clear, the Fed’s own misperceptions of the natural rates have sometimes caused policy to stray far off track. During the 1970s, for instance, Fed officials consistently underestimated the natural rate of unemployment u-star. Believing that there was more slack in the economy than there actually was, they adopted policies that were far too accommodative, fueling the sustained rise in prices now known as the “Great Inflation.”
Although Fed policymakers have always resisted calls to announce a specific rule—a concise formula summarizing their strategy for adjusting the funds rate in response to changes in inflation, unemployment, and perhaps a small number of other key macroeconomic variables—adopting such a rule would help them greatly in coping with the risk and uncertainty emphasized in Chair Powell’s speech. Without a rule, central bankers appear instead to be making decisions on a meeting-by-meeting basis, without any consistent link to either the past or the future. That discretionary feature of policymaking leaves them vulnerable to unfair criticism, as outsiders can always look back with the benefit of hindsight and point to things the Fed should have done, without having to propose a strategy of their own that works better in real time. The Fed could protect itself against these attacks by identifying a rule that acknowledges uncertainty about the workings of the economy and delivers acceptable results nonetheless; the onus would then shift to the critics to find an even better rule. This was the lesson that the economist Athanasios Orphanides, my colleague on the Shadow Open Market Committee, drew from his careful study of the mistakes the led to the Great Inflation. Chair Powell’s speech highlights how that lesson applies with equal force today.
As a matter of fact, monetary economists have often used arguments like Chair Powell’s to stress the advantages of policy rules. Milton Friedman, for example, based his case for the simplest policy rule, to stabilize the money growth rate, on the idea that “we cannot predict at all accurately just what effect a particular monetary action will have on the price level and, equally important, just when it will have that effect. Attempting to control directly the price level is therefore likely to make monetary policy itself a source of economic disturbance because of false stops and starts.”
Likewise, the late Allan Meltzer identified the “monetarist propositions” that underpin his argument for rules: that economic forecasts are never accurate enough to allow the central bank to perfectly smooth out fluctuations, that long and variable lags make it impossible to predict the timing with which policy actions will affect the economy, and that the private sector operates most efficiently when policymakers remove their own actions as a source of risk and uncertainty. “The required level of information for a successful discretionary policy,” Meltzer concludes, “is simply not available.”
Precisely because of the risks and uncertainties that are the focus of Chair Powell’s comments at Jackson Hole, a more rule-based approach to policymaking would serve the Fed best at present. By adopting and announcing a specific monetary policy rule, the Fed would protect itself from unfair ex-post criticism and remove uncertainty about its own policy actions as a source of unwanted economic volatility.
Peter Ireland is a Professor of Macroeconomics at Boston College and a member of the Shadow Open Market Committee. He will discuss these and related monetary policy issues at the SOMC’s October 19 meeting in New York, co-sponsored by Economics21. Follow him on Twitter Economics21 at the Manhattan Institute.
Editor’s Note: This piece was originally published by Economics21 at the Manhattan Institute.