There are two ways to conduct monetary policy. One approach is to give monetary policymakers the discretion to decide their policy at any time they see fit. Another approach is to have them adhere to and follow a monetary rule that determines how monetary policy should develop. The Fed’s slow response to high inflation over the past year suggests that we would be better off if there was a monetary base.
Advocates of freedom of action believe that it is unwise to tie the hands of central banks to a monetary base. The monetary base cannot be changed to take account of unforeseen circumstances. They argue that discretion gives the central bank the flexibility to do what it needs to do in a crisis.
Defenders of monetary rules accept that the rule may prevent a central bank from doing what it should in some exceptional circumstances. But, contrary to discretion, the rule will do Requires The central bank should do what it must in all other cases. Hence, the performance of a rule relating to a discretionary central bank largely depends on the extent to which the rule can determine the optimal monetary policy in advance, and the probability of the central bank doing what it must if it is not required to do so. base.
Those who favor discretion often ignore the trade-off between rule and discretion by assuming that monetary policy makers will react appropriately as events unfold. However, the Fed’s reaction over the past year provides plenty of room for doubt. Rather than evolving with the available data, as President Powell has repeatedly claimed the Fed would, the Fed has been slow to react.
By October 2021, it was clear that production was recovering rapidly from the COVID-19 downturn. But prices have not returned to trend. Keep rising! However, Chairman Powell and other members of the Federal Open Market Committee (FOMC) continued to insist that inflation was temporary until the end of November. The FOMC finally acknowledged that inflation was at least partly driven by demand in December 2021. But it failed to take immediate action. Instead, he set a path for a modest rate hike in March 2022.
Once the Fed had this plan, they stuck with it for a very long time. Month after month, the data showed that inflation was worse than expected. But the Fed has not revised its plan. The Fed didn’t take serious action until May 2022, when it raised the federal funds rate by 50 basis points. It did not break the path with the plan it set in December 2021 until June 2022, when it surprised markets with a 75 basis point interest rate hike. For nearly six months, the Fed failed to respond to incoming data. I’ve kept the course blindly.
The discretionary nature of the Fed makes it difficult for companies to plan by making it unclear how the Fed will react to the new data. Under the monetary base, firms must anticipate the demand for their output and the supply of their inputs. With discretion, they must also predict what the central bank will do, as this is not predetermined by a rule. Even if a rule cannot be fully adhered to, it may nevertheless provide guidance on how monetary policy should evolve Given the unexpected departure from the norm. With discretion, there are no such assertions.
Discretionary monetary policy also depends, to a greater extent, on the particular individuals present in the place. The composition of the FOMC can change suddenly due to regular rotation (in the case of regional reserve bank chairs) or new appointments. The latter makes it particularly difficult to predict how monetary policy will be conducted. It’s hard to know how FOMC members are likely to vote at some upcoming meeting if you don’t know who they are yet. Consider, for example, that the Federal Open Market Committee started the year with three vacancies. Philip Jefferson and Lisa Cook were added in May. Michael Barr was added in July. Before their respective assertions, no one trying to predict monetary policy knew about it whether Jefferson, Cook or Barr will help make important monetary policy decisions, not to mention How They will make such decisions.
Some will be inclined to write off these personnel issues as insignificant. But they were very important in the past. When Benjamin Strong fell ill in late 1927, he lost his influence and was eventually replaced by George L. Harrison. Some have speculated that the Great Depression could have been avoided if Strong’s untimely death had not been for him.
The monetary rule is not a panacea. But a good rule can outperform discretionary monetary policy. A good monetary base does not only determine the appropriate course of action in advance. It also requires monetary policy makers to take this path, and in doing so reduce the uncertainty that businesses and consumers face.