Formulation of Monetary Policy by the Federal Reserve: Rules vs. Discretion (CRS Report for Congress)
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| Release Date |
July 19, 2001 |
| Report Number |
RL31050 |
| Report Type |
Report |
| Authors |
Marc Labonte, Government and Finance Division |
| Source Agency |
Congressional Research Service |
Summary:
Would the economy be better off if the responsibility for setting the federal funds rate were taken
from Federal Reserve (Fed) Chairman Alan Greenspan and his colleagues on the Federal Open
Market Committee (FOMC) and replaced by a simple rule? A surprising number of economists
would answer yes. John Taylor, now an Undersecretary of the Treasury, formulated what is now
called the "Taylor rule" in which interest rate changes would automatically be based on gaps between
inflation and growth and their desired or sustainable long-run rates.
Some Members of Congress have expressed a dissatisfaction with the Fed's use of discretion,
and have sought alternative policy options; rules offer one alternative. Although day-to-day control
of monetary policy has been delegated to the Fed, the ultimate goals are determined by Congress.
Thus, Congress retains the right to change the current personal, discretionary regime to a monetary
policy based on a formula incorporated in a rule.
Proponents of using a rule such as the Taylor rule argue that basing policy on explicit,
quantitative goals would promote economic efficiency and individual decision making because it
would eliminate monetary policy "surprises" inherent in the informal discretionary process now in
place. Rule proponents point to the 1970s when they believe poorly executed discretionary policy
led to double-digit inflation despite sluggish economic growth. They attribute this to the Fed's
unwillingness to accept slower short-term growth for the sake of price stability and to resist "fine-
tuning" policy in the pursuit of unrealistic goals. The steps ultimately taken to regain control over
the resulting inflation caused the worst recession since the Great Depression. It is argued that if the
Fed's credibility had not been so low by this point, inflation could have been eliminated with a much
milder recession.
Under a rule, necessary but politically unpopular decisions would be automatic - inflation could
no longer drift upward in pursuit of temporary employment gains. Switching to a rule could reduce
uncertainty, enhance credibility and accountability, and improve monetary policy effectiveness. To
those who see the current regime as undemocratic, rules offer a way to limit the discretionary power
of the unelected FOMC.
Defenders of discretionary policymaking argue that setting monetary policy in a highly complex
economy cannot be reduced to a single equation. They point out that this is especially true at times
of financial crisis, when the Fed's ability to increase financial liquidity is instrumental for quelling
panic. Discretionary policy may have been executed poorly in the 1970s, but the 1990s economy
has enjoyed low inflation and high, stable economic growth. They also question the real-world
usefulness of the simple models that rule proponents use to demonstrate the superiority of Taylor
rules. There are a number of practical problems that would arise if a Taylor rule were implemented.
These include lags in the effectiveness of monetary policy, shortcomings with economic data, and
uncertainty about key economic variables such as the natural growth rate. There are no plans
to
update this report .
