House Republicans have a potentially dangerous idea for the Fed

Jeb Hensarling, the top Republican on the House Committee that oversees the Federal Reserve, wants to change up the way the country does monetary policy. It's a technical-sounding change — he wants rules-based monetary policy — ostensibly aimed at making Fed actions more predictable. But it would have wide-ranging, and potentially negative, consequences for things everybody cares about, like job creation and wage growth.

At an oversight hearing this week, Hensarling pushed Fed Chair Janet Yellen on why she doesn't support this kind of framework and she pushed back. This debate is much more important than it superficially sounds. Following Hensarling's preferred framework over the past 12 months, for example, could easily have denied the country the economic improvement that we've been enjoying.

What does Hensarling want?

He wants the Fed to set interest rates according to a formula, rather than according to human judgment. The rule that gets the most attention usually is the Taylor Rule. Hensarling has this rule in mind — he asked Yellen, "Do you no longer believe that a rules-based policy like the Taylor Rule is what sensible central banks do?" as the New York Times reported. It's a formula that economist John Taylor proposed in 1993, in which the Fed changes short-term interest rates based on a calculation that factors in inflation and economic growth.

Rules-based policy could work in any number of ways, but Taylor laid out his vision for it in the Wall Street Journal last year: "The Fed, not Congress, would choose the rule. But the rule would be public. If the Fed deviated from it, the Fed chair would be obligated to explain why, in writing and congressional testimony."

Instead of rules-based policy, the Fed uses discretionary policy — that is, it doesn't use a stiff framework for making decisions, but rather makes more flexible decisions based on current economic conditions.

How would the Taylor Rule have changed recent Fed policy?

The Fed would have raised interest rates earlier, slowing economic growth. As Taylor told the Journal in June of last year, the federal funds rate would have already been above 1 percent at that time under his rule (currently, it's near zero, where it has been since the very end of 2008).

And according to these charts from the Fed, under a modified Taylor Rule, the federal funds rate would lift off much quicker than what the central bank considers optimal.

(Federal Reserve)

Not only that, but a Taylor Rule would mean higher unemployment and inflation well below target the rate would never have even gotten to its current near-zero levels at the height of the crisis.

(Federal Reserve)

What this shows is that Taylor Rule recommendations can deviate sharply from what's generally considered good policy.

Low interest rates encourage borrowing, and therefore spending, on both business investment and major consumer goods like houses and cars.

Raising the rate earlier would have slowed economic growth — the fed is tasked with creating full employment, and even with the federal funds rate near zero right now, we're still not at full employment, and inflation is still below two percent. There's clearly room for more stimulus even today. Dialing it back earlier could easily have resulted in higher unemployment and slower growth — meaning an even more painful recovery than we have now.

But don't we want predictability?

Sure! But it's not as if the Fed is dropping surprise policy bombs right now — for example, it hinted at a taper for months before it started dialing back QE3 (the third round of quantitative easing).

And that's because one key tool of the Fed's discretionary policy in recent years has been forward guidance: that means the Fed telegraphs what it expects to do using speeches, statements, and hearings like Yellen's this week. This is a way of introducing Fed-watchers and markets to how the Fed's assessment of the economy is changing and therefore to what might happen to Fed policy in the coming months.

Who supports formula-based monetary policy?

The discretionary-versus-rules debate comes up regularly and has for decades. And at the Fed, as Taylor has pointed out, the pendulum has swung back and forth — in the 1960s and 1970s, policy was more discretionary. In the 1980s and 1990s, it was more rules-based. Since the crisis, it has been more discretionary again.

Currently, Taylor is of course a big proponent of it, but Republicans like Hensarling also promote it. Philadelphia Fed President Charles Plosser has advocated rules-based policy.

One key argument for a rules-based framework is predictability, as Hensarling said in his opening statement: even slight wording changes in Fed statements or the slightest mention of policy changes by former Fed Chair Ben Bernanke at times have led to huge stock market spikes or drops.

Another is that creating hard and fast rules prevents markets from second-guessing the Fed.

"The problem with discretion is a problem of credibility. ... In some way what the central bank may want to do is commit to low inflation but use discretion to create a little more inflation than expected and stimulate the economy," says Adolfo Laurenti, deputy chief economist at Mesirow Financial in Chicago. "The problem is that market participants know that. Market expectation will fully anticipate the surprise and if the surprise is anticipated it's not a surprise anymore."

That's an important point: people like Hensarling, Taylor, and Plosser aren't in favor of rules-based policy because they happen to like rules. The fear is that in using its discretion, the Fed will allow inflation to creep too high and eventually get out of control.

More broadly, Laurenti is getting at another very real concern: do what you say you're going to do, and your policy will work, but deviate from any guidance you've given, and your policy will undermine itself (not to mention whether markets believe you in the future).

So could you write a rule that works?

That seems near-impossible, according to one expert.

"The real key here is that the US economy consists of billions of individual transactions. Thinking about assigning a rule which encompasses the dynamics of all those transactions — those rules would be too complex to be imagined," says Guy LeBas, chief fixed income strategist at Janney Montgomery Scott.

He gives the financial crisis as an example — it's easy to imagine that operating under strict rules could have caused the Fed to react more slowly. The hundreds of billions of dollars of assets it bought in November 2008 under the first round of quantitative easing, or the rapid ratcheting-down of interest rates throughout 2008, might have been slower under a rule.

Another issue here is that the economic landscape has changed since the Fed's more rule-based approach that it took in the 1990s. Back then, the fear wasn't deflation but making sure inflation stayed under control, and job growth was strong.

"For 30 years what we were really fighting was inflation, and the rules ended up to be a very good way to deal with inflation and a really changing the market expectation in regard of inflation," says Laurenti. "What we have been struggling in the last five to six years is really more deflationary pressure."

Yellen has said that while rules can work, a recovery from a devastating recession is simply no time for it. As she said in November 2012, "[T]imes are by no means normal now, and the simple rules that perform well under ordinary circumstances just won't perform well with persistently strong headwinds restraining recovery and with the federal funds rate constrained by the zero bound."

It may also be that the Taylor rule in particular is only applicable when inflation-curbing is the order of the day and not job creation. The New York Times' Binyamin Appelbaum explains this well in his piece on the Wednesday hearings.

"The Yellen Fed regards job growth as its priority, a transformation so complete that hewing to a Taylor-style rule actually would curb the Fed's stimulus campaign," he writes.

I have no interest in finance. Does this even matter for me?

Absolutely. The Fed is instrumental in stabilizing the economy, and that's important during huge shocks. Predictability and avoiding surprises may be helpful in the short run, but there's also a big price to be paid if the Fed is less flexible.

Had the Fed not been able to respond rapidly during the financial crisis, it could have meant an even deeper recession, meaning deeper unemployment and an even longer recovery than the one we're experiencing.

Not only that, but the Fed has also found that the economy doesn't always behave they way they think it will. In 2013, they dropped the "Evans Rule" (which wasn't so much a rule as a guideline). The Fed had said it would keep interest rates low at least as long as unemployment was above 6.5 percent and inflation below 2.5 percent. As unemployment approached 6.5, it became clear that there was still room for more stimulus, and the Fed dropped the language. Indeed, even with unemployment at 5.7 percent now, inflation has yet to hold above 2.0 percent.

In the recovery, even numbers are fickle. Being a slave to them for the sake of predictability can mean sacrificing economic growth — and, therefore, average peoples' wages and job stability — for the sake of making sure there are no policy surprises. In the end, that seems like an uneven tradeoff.

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