How rules-based Fed policy can reduce recession risk and fight inflation

Despite dismal stock and bond market performances, the Federal Reserve has done the right thing by raising interest rates and selling off part of its bond portfolio (quantitative tightening) to combat inflation. Now, anxious investors are wondering when the Fed will slow and eventually stop its interest rate hikes. There is no consensus about how much tightening is enough. But the risk or severity of a looming recession becomes more pronounced each day it persists.

This is the Federal Open Market Committee (FOMC)’s dilemma. If it slows the rate increases to avoid recession, the public may lose confidence in its willingness to reduce painful inflation to the 2 percent target. To give itself more flexibility in the short run and convince the public it’s serious about inflation, the FOMC should commit itself to a new rule — one more specific than its current policy of average inflation targeting. One such rule would be a firm commitment to limit the growth of total spending.

Monetary economists have long debated between rules-based and discretionary monetary policy. Proponents of discretionary policy argue that the FOMC should use its members’ expertise to make decisions in response to all available economic information. During the pandemic, the FOMC pursued this policy. Chairman Powell acknowledged the intention to allow inflation to rise to restore full employment. But the resulting inflation was higher and longer lasting than the Fed anticipated, leading to the harsh corrective measures now under the microscope.

Rules-based policy would instead constrain the FOMC’s options so as not to change policy in response to short-run political pressure. A target growth rate for the total dollar value of spending in the economy – a measurement that rises or falls with the rate of inflation – would simply tighten monetary policy when spending grows too fast and loosen it when spending undershoots the target. This approach is objective and leaves other government officials and the private market in a better position to anticipate and adjust to inflation (and to address economic issues which the Fed does not influence as effectively, such as employment).

If the Fed adheres to such a target in true rules-based fashion, it communicates what to expect from our monetary leaders. For example, if the public expects high inflation to decrease, workers should be willing to accept smaller wage increases, which in turn means cash-strapped firms won’t need to raise future prices as much. Without this type of policy clarity, wages might increase rapidly even as the Fed tightens monetary policy, making a recession accompanied by rising unemployment likelier. News about recent wage increases suggests this might be a problem today, though more analysis is needed.

Looking to the history of these approaches, during the 1970s, the FOMC pursued what former Federal Reserve Bank of Richmond economist Robert Hetzel describes as a discretionary policy of “aggregate demand management intended to balance off low inflation and low unemployment.” By allowing the money supply to increase rapidly to bring down unemployment, Fed policy resulted in rising inflation and inflation expectations. The FOMC increased the money supply even more rapidly during 2020 and 2021.

When Paul Volcker and Alan Greenspan later served as chairs, the FOMC pursued something closer to a rules-based approach, emphasizing price stability and leaving employment to market forces operating in a predictable policy environment. They both recognized that price stability and low unemployment are compatible long-run goals. If the economy is experiencing a recession and unemployment, the recovery does not require high inflation.

In a forthcoming Mercatus Center special study, Hetzel argues that we need a vision of where future policy is headed — one articulated not just to restore price stability but to maintain it indefinitely. This can be done with a benchmark path for growth in total spending that gradually decreases until consistent with 2 percent inflation. As part of this, the Fed should avoid pursuing employment goals independent of price stability.

Fed policy will be more effective if the public is convinced that nothing will interfere with its core commitment. Reduced inflation expectations contribute to lower actual inflation and lower unemployment. If the FOMC were to moderate its interest rate increases over the next few months, and communicate how exactly it intends to continue to reduce inflation and maintain it at 2 percent, policymakers and the market will listen. That’s especially true if the Fed acknowledges that inflation is largely the result of monetary policy, and that it will preemptively limit future inflation in a way that it failed to do in 2020 and 2021.

Although economists cannot be sure how much interest rates need to increase to beat inflation, or whether the expected trajectory of interest rate increases will cause a recession, the Fed could do a better job with a well-specified monetary policy rule reflecting commitment and clearer priorities in the future.

Tracy C. Miller is a senior policy research editor with the Mercatus Center at George Mason University.