Monetary policy is generally as exciting as say Olympic curling_ only a small corner of the universe generally gets excited. But an intellectual brawl broke out Friday over how the Federal Reserve communicates what is driving its decision making.
At issue is the Fed’s controversial bond buying program, recently tapered back by $20 billion a month but still happening at a monthly pace of $65 billion. More narrowly, the debate is over the so-called Taylor Rule, which generally prescribes what interest rate should be charged by the Fed given certain economic conditions such as inflation, output and growth.
The Taylor Rule, named after Stanford University conservative economist John Taylor, seeks to promote financial stability by making it clearer what conditions prompt which responses.
Critics of the Fed complain that the central bank has gotten away from longstanding practices of relying on rules to make its decisions and then communicate them. Chief among the critics is Taylor, a former top Treasury Department official who came up with his rule in the early 1990’s.
The new chairman of the House Financial Services Committee_ Texas Republican Rep. Jeb Hensarling_ took the unusual step of having Taylor testify before his committee earlier this month right after it heard from Janet Yellen on Feb. 11 in her first congressional testimony as Fed chief. Hensarling lamented that the Fed is moving away from rule-driven guidance to financial markets.
Taylor told the committee that the Fed began abandoning rule-based decisions in 2003, and did so altogether after the 2008 financial crisis.
“An alternative more rule-like policy would have worked better during this period, and a return to such a policy would help restore stability and strong sustainable growth in the future,” Taylor said in prepared remarks, calling for legislation that’d force the Fed into rules-based decisions.
Taylor’s criticism was answered in a scathing speech Friday by Charles Evans, president of the Federal Bank of Chicago. Speaking at a University of Chicago Booth School conference in New York, Evans ripped into critics.
If followed in 2009, he said, the Taylor Rule would have demanded that the Fed do something that was mathematically impossible, lower interest rates to below zero.
“Of course the rule completely breaks down during the Great Recession and its aftermath. It says to set the federal funds rate at minus 5 percent in 2009. We can’t do that,” Evans said. “Moreover, there is no emergency handbook that comes with the rule that says what to do in this event.”
That leaves the Fed in a state of inaction, “and inaction looks like policy abdication and a failure to make timely progress in reducing policy imbalances.”
The Fed has held its benchmark rate at about zero since December 2008, and Taylor believes the rate should now be at 1.25 percent. The trillions the Fed has purchased in government and mortgage bonds are designed to approximate the effect of lowering interest rates below zero.
The bond buying has shifted the relative value of different financial instruments to each other, boosting the price of stocks and commodities and lowering returns for bond investors. The effort has also brought down long-term borrowing costs for consumers and businesses in support of the broader economy.
While the bond buying seems to have helped, there are growing fears about financial turmoil as the stimulus ends and financial markets find their bearings. Mortgage rates jumped a full percentage point last year when the Fed signaled its intent to pull back on bond buying.
In a lunch address before Evans spoke, former Treasury Secretary Robert Rubin acknowledged he’s among those who worry about the pullback and felt the effort had done more potential harm than good. As to whether the Fed can pull off a trouble-free withdrawal, “I think it is impossible to tell at this time,” he said.
Rubin also said what the Fed has not, that the pullback of stimulus has been harmful to large emerging economies as investors seek to rebalance amid a changing financial landscape.
Steering clear of the Taylor Rule dispute, the president of the Federal Reserve Bank of Philadelphia, Charles Plosser, acknowledged that communicating the Fed’s intentions under such usual circumstances is proving difficult.
“If policymakers aren’t relaying on a rule policy then becomes discretionary and forward guidance becomes ineffective,” Plosser said.
That was a nod to Taylor’s complaint that the Fed’s discretionary approach creates uncertainty for long-term investors and the Fed’s mission is to create certainty about future direction of inflation, employment and growth of the economy.