SHOULD the US Federal Reserve Bank engage in a rule-based monetary policy and abandon its discretionary-based monetary policy?
The Fed’s mandate of achieving low unemployment and low inflation is entrenched in its Federal Reserve Act, Section 2A, 1977 amendment; US Congress, 1977, whereby – “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates”.
Monetary policy based on rules has an advantage, transparency, but it has never been the central argument for a monetary rule. The central argument for a monetary rule is what is known as the knowledge problem in economics.
In principle, policy makers cannot possess all the knowledge required to devise an optimal or time consistent monetary policy, given the information required for centralised policy making is dispersed among millions of economic actors in the economy.
It can’t be aggregated in a single mind and it is here where discretionary monetary policy comes into play.
During the Global Financial crisis of 2008-2009, the Fed operated within a discretionary policy framework.
Monetary policy accommodation in the form of quantitative easing (QE) was engineered by the Fed long after the end of the recession and even six years after the end of the recession the Fed has yet to begin the process of normalisation.
Which begs the question what exactly is the Fed’s discretionary-based monetary policy? Currently, the Fed employs discretionary-based monetary policy without any rigid operational framework.
The Fed does operate under the so-called dual mandate, statutory language that directs it to promote both price stability and low unemployment, but has no binding requirements to hit any specific economic goals.
Proponents of this type of discretion-based policy claim that the enormous complexity of the ever changing economy requires broad discretion, but the nature of the economy actually makes the case for rules based policy.
Rule-based monetary policy overcomes a major credibility problem that the Fed faces. A clear policy rule commitment would bind the Fed to a future course of action based on clearly defined economic outcomes, this in turn reduces uncertainty with respect to future policy changes.
Rule-based monetary policy that is properly structured helps to prevent short-term considerations such as temporary cyclical fluctuations from interfering with the Fed’s long-term goals.
In the case of the September Federal Reserve Open Market Committee (FOMC) meeting, the communique was devoid of any meaningful forward looking information aside from indicating that “When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2%.
The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run”.
Implying the Fed will continue to use its discretionary based approach in determining the direction of monetary policy even after employment and inflation are near mandate-consistent levels.
For financial markets on the other hand, sitting at the edge of the “rates lift off” will remain for a considerable period of time.
The Fed’s fear of lift-off, the reluctance to start the process of policy normalisation after the end of a recession is a clear example of the Fed wanting to continue using the discretionary approach in its monetary policy.
But it fails to foresee the fact that this very fear itself makes discretionary based monetary policy even more difficult to be implemented and interpreted in the market place giving rise to unnecessary volatility.
The Fed needs to adopt a framework that relies on policy rules that is subject to period reviews and adaptation. It needs to replace its meeting by meeting discretion with simple policy rules that circumvent discretion in favour of systematic policy.
Periodic review of the rule would allow the Fed the flexibility to account for and occasionally adapt to the evolving understanding of the economy. The longer the Fed stays on the path of discretionary based monetary policy, deeper the pain for Emerging Markets in particular.
Dr Suresh Ramanathan is an independent interest rate and foreign exchange strategist who has spent 20 years in several onshore and offshore financial institutions. He can be contacted at email@example.com