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A Case for a Monetary Rule: It's Time to End the Fed's Discretion

December 22, 2014 in Economics

By James A. Dorn

James A. Dorn

The Federal Reserve has long been the world’s most powerful central bank and has become even more so since the 2008 financial crisis. The Fed chairman not only has wide discretion over the course of monetary policy but also over financial regulation. With a Congress that has abandoned its constitutional duty to safeguard the value of money, the Fed chairman is more powerful than the President.

In an uncertain world, rules are necessary to limit power and bring about order. The institutional and property rights structure comprise the rules of the game. To be effective, rules must be enforced and widely accepted. This is as true for rules of the road and sports as it is for monetary rules.

The classical gold standard was successful because the rules were generally accepted and the convertibility principle was enforced. Trust in contracts with the promise of redeeming currency and deposits for specie meant that people had confidence in the long-run value of money. There was no need for fancy macro models or for a data-dependent monetary policy. Sound money, free trade, and the absence of capital controls helped produce a harmonious international monetary order.

Today we live in a pure fiat money world. The Fed has a dual mandate to promote price stability and full employment, but there is no monetary rule. Monetary policy depends on forecasting the real economy — and the Fed’s forecasting record is dismal. Not one of the Fed’s large staff of top university PhD economists forecast the Great Recession. The Fed chairman did not predict the subprime crisis or the Great Recession, and the Fed’s army of sophisticated models didn’t predict it either.

Actual data is always backward looking, no one knows the future. Yet, Fed Chairwoman Janet Yellen and her Federal Open Market Committee base their decisions about the course of monetary policy — that is, their stance on the benchmark federal funds rate — on guesses about the path of the economy.

Interest rate projections from different Fed officials range from 0.375 percent to 4 percent for year-end 2016, indicating a wide variation in expectations about inflation and the real economy. Of the 17 officials who submitted forecasts at the recent FOMC meeting, most predicted short-term rates to edge up by mid-2015, with a median estimate of 1.125 percent by the end of 2015. The median estimate for 2017 was 3.625 percent. Such spuriously precise predictions — using …read more

Source: OP-EDS

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