Should the Federal Reserve follow rules or use its own discretion? For Republican lawmakers intent on hemming in the central bank’s powers, the answer is clear: Fed policymaking should be rules-based. For Janet Yellen, who started her tenure as Fed chair just a few weeks ago, there’s a pressing need for creative responses. She favors rules, too, but wants latitude now to stretch the boundaries of central banking.
“The extraordinary measures of 2008 have seemingly morphed into the ordinary measures of 2014.”—Jeb Hensarling
Led by House Financial Services Committee Chairman Jeb Hensarling of Texas, Republicans have accused the Fed of following a haphazard, discretionary policy that investors have found hard to fathom and that has done little to help the economy, as it recovers slowly from the worst crisis since the 1930s. As an alternative, they want Yellen and her colleagues to adopt guidelines that they say would be more understandable and reliable. “We are into an improvisation phase where an incredible amount of discretionary power has been imparted upon the unelected and relatively unaccountable,” Hensarling says. “I don’t think that is good for promoting long-term economic growth.”
The debate has even resonated recently within the Federal Open Market Committee, the Federal Reserve body that sets monetary policy. Two FOMC participants noted that some standard economic rules suggested the central bank should raise interest rates before the middle of the year, according to the minutes of the committee’s last meeting on Jan. 28-29. Others argued that a rate hike was “not appropriate in current circumstances.”
In a rules-based approach, the Fed would likely have the same reaction every time the economy behaved a certain way. So if inflation rose a prescribed amount, an investor could assume the Fed would respond in predictable fashion. The rules, based on academic work, wouldn’t be complicated. One guideline the Fed would consider adopting is the Taylor rule, developed by Stanford University economist John Taylor, which links monetary policy moves to changes in inflation and the economy. Applying the Taylor rule would call for the Fed to raise its short-term interest rate target to 1.25 percent, from zero now. Taylor, who served in the Department of the Treasury under President George W. Bush, says he wouldn’t advocate a move immediately because the markets wouldn’t be ready.
Yellen told Hensarling’s committee at a Feb. 11 hearing that she has “always been in favor of a predictable monetary policy.” The trouble is that rules such as Taylor’s aren’t applicable now because “the conditions facing the economy are extremely unusual,” she said.
The argument over monetary-policy rules dates back to the mid-1800s, when British parliamentarians debated the structure of the Bank of England. Those who favor discretion argue that central bankers need leeway to respond to changes in the economy. Supporters of rules contend that a more predictable policy enables companies and consumers to plan for the future.
The increased focus on rules isn’t surprising given the measures the Fed took to counteract the financial crisis, says Benjamin Friedman, a professor of political economy at Harvard University. Those measures included pumping liquidity into the financial markets, successive rounds of bond purchases, lowering the benchmark interest rate to zero, and offering increasingly specific guidance on the Fed’s interest rate intentions. “The extraordinary measures of 2008 have seemingly morphed into the ordinary measures of 2014,” Hensarling says. He supports former Texas Representative Ron Paul’s proposal to subject the Fed’s operations, including its monetary policy, to a full audit by the Government Accountability Office, the investigative arm of Congress. Yellen has opposed such a move, saying it would interfere with the central bank’s independence to set policy.
Hensarling says his committee is planning an “aggressive series of hearings” this year with the aim of developing legislation to change how the Fed operates. The project will focus on, among other things, the Fed’s “role in the explosion of the national debt” and “the impact accommodative monetary policy has on seniors.” (Elderly Americans living on bond coupons and savings accounts are suffering now that rates are near zero.)
Republican Representative Kevin Brady, the chairman of Congress’s Joint Economic Committee, last year reintroduced his bill to overhaul the Fed after first proposing it in 2012. Called the Sound Dollar Act, the proposal would narrow the central bank’s focus to controlling inflation, eliminating its other mandate to promote full employment.
The legislation, with 52 co-sponsors, would restrict the Fed’s asset holdings to Treasury securities, speed the release of FOMC meeting transcripts, and give all 12 of the Fed’s regional bank presidents permanent votes on monetary policy, instead of the current rotating system where just five take part at a time.
The measure faces an uphill battle in the Democrat-controlled Senate, where a companion version has been introduced by Utah Republican Mike Lee. But the topic of rules vs. discretion at the Fed is one the GOP won’t easily give up on.