The importance of rules in Federal Reserve policymaking

The Federal Reserve is re-examining its monetary policy strategy. It is considering whether alternatives to the present inflation-targeting framework could be more efficient and transparent in helping it attain its core macroeconomic objectives of price stability and maximum employment, while maintaining its independence. My research provides ample theoretical, empirical and historical evidence that can help the policymakers in their pursuit.

Based on the historical record of the United States, I found that the pursuit of stable monetary policy guided by central banks following rule-like behavior results in low and stable inflation, produces stable real performance and encourages financial stability. 

History teaches us that episodes of sustained expansionary monetary policy – stimulating the financial economy in excess of the real economy’s potential growth rather than adhering to a credible monetary rule – can create inflation.  

Sustained slow monetary growth relative to potential growth will lead to deflation and, in the face of nominal rigidities, recession.

The classical gold standard, in practice from 1880 to 1914, was based on a credible monetary rule, pegging the value of the dollar to a fixed weight of gold (by fixing the price of gold in terms of the dollar) and requiring the monetary authorities to maintain the peg above all else. This rule precluded both discretionary monetary policy and the running of fiscal deficits. The gold-standard era was associated with long-run price stability and good real economic performance.

The Great Moderation period, from 1985 to 2005, based on a fiat money–based “credibility for low inflation” rule, also exhibited exemplary price stability and real economic performance. It had some of the features of the gold standard without the resource and other costs of having a commodity-based system.

Discretionary monetary policy (expansionary or contractionary) based on fine tuning can exacerbate the business cycle. Moreover, the record of the Federal Reserve, as documented in my book, shows it has often been too late in exiting from expansionary policy as the economy recovers and too slow in recognizing recessions.

Recent U.S. experience also shows that such expansionary policy can produce asset price booms (in stocks, real estate and commodities). This can lead to future inflation, as was the case in the 1970s. Asset price booms can also end in busts that lead to or worsen financial crises, as occurred in 2008.

Financial crises can severely impact the real economy. Banking crises since the 1970s have led to bailouts, which in turn increased fiscal deficits and national debt. Fiscal bailouts can lead to monetization by the monetary authorities and inflation. Finally, price level and inflation variability can lead to and exacerbate financial instability.

The failure to adhere to rules that produce monetary stability will inevitably produce the dire consequences of real, nominal and financial instability. The case for monetary rules instead of central bank discretion can be traced back to the famous Currency Banking School debate in early 19^th century England. This was followed by the approach taken by the Chicago School, first with Henry Simons in 1936 and then with Milton Friedman in 1960, with his “k percent rule.” Under the k percent rule, the central bank would set the rate of monetary growth equal to the long-run growth of real income adjusted for the trend growth of velocity. Adhering to Friedman’s rule would maintain stable prices.

Friedman’s rule was improved upon by John Taylor in 1993, who based his rule on the policy instruments that central banks actually use. Under this monetary rule, the Fed would set its rate according to the natural rate of interest and a weighted average of the deviations of inflation from its target and real output from potential output. Since its advent, the Taylor rule has been widely accepted as a best practice.

In view of this background, policy performance can be compared across different historical regimes: in addition to the classical gold standard (1880–1914), the interwar period (1919–1939), the Bretton Woods period (1959–1971) and the current managed float (1971–present). The interwar period stands out as having the worst economic performance, which could have been avoided if the Fed had followed a stable monetary rule. Similarly, the Great Inflation (1965–1982) was an episode that could have been avoided with stable rule-like policy.

Further episodes of disinflation, recovery, asset price booms and busts, credit crunches, banking crises and a gamut of macroeconomic disturbances throughout the Fed’s history echo the underlying lesson: the benefits of stable and consistent rule-like monetary policies.

Michael D. Bordo is a distinguished professor of economics at Rutgers University and a distinguished visiting fellow at the Hoover Institution at Stanford University. His most recent book, published in June 2019, is “The Historical Performance of the Federal Reserve: The Importance of Rules.”