Monetary Rules vs. Discretion

2. Monetary Rules vs. Discretion Scott Sumner, Bentley University and the Mercatus Center

3. Three Types of Monetary Policy • Setting the price of money (in terms of a commodity, a foreign currency, the CPI basket or NGDP.) • Setting the rental cost of money (interest rate targeting) • Setting the quantity of money (the monetary base, M1, M2, etc.)

4. The price of money approach • Pure commodity money: gold or silver standard 1. Money defined as a fixed weight of gold or silver. 2. Government need not play any role. • Targeting rule: Monetary policy used to target price of gold, foreign exchange, CPI or NGDP

5. Two Types of Policy Rules • Instrument rules: A specific procedure for adjusting the policy instrument. Example: The Taylor Rule provides a formula for adjusting interest rates, aimed at stabilizing the economy. • Target Rules: A specific objective for the goal or goals of monetary policy Example: A 2% inflation target, or a 4% NGDP growth target, level targeting.

6. Interest rates are generally a policy instrument, not a policy goal. 1. “Policy rule” terminology leads to confusion. Monetary policy can generally hit only one external target at a time. However, you can target both interest rates (instrument rule) and inflation (target rule) at the same time. (i.e. Taylor Rule) Analogy: The target setting of a ship’s steering wheel (instrument), and the target destination (goal). 2. While interest rates are the most common policy instrument, other options are possible, including the monetary base (QE), exchange rates (Singapore), and gold prices (FDR during 1933).

7. Money supply targeting • Stable growth rule for the monetary base, M1 or M2 • Base money is clearly controllable, but was not a good policy indicator during 1930-33, or 2008-13. • Friedman favored a M1 or M2 target growth path of 3% or 4%/year (until late in his career.) • Are M1 and M2 controllable in a liquidity trap? • Would velocity be stable under M1 or M2 targeting?

8. Stylized history of US policy regimes 1. Relatively laissez-faire gold (or bi-metallic) standard. (before 1914) 2. Increasingly managed gold exchange standard (1914 to March 1968) 3. Unanchored fiat money regime (1968-81) 4. Move toward inflation targeting (1982-today) Compare best with best (#1 and #4), or worst with worst (#2 and #3)

9. Unstable gold demand is the problem • Global stock of gold grows fairly steadily over time, at roughly 1% to 2.5%/year. • Gold demand is more unstable: • The nominal interest rate is the opportunity cost of holding gold. (Gibson Paradox: Barsky and Summers (1988)) • Economic growth impacts gold demand (China, India, etc.) War often reduces gold demand.

10. The global gold market

11. The price level during and after the gold standard

12. Discretionary fiat regime • Policy became increasing expansionary and unstable during the 1960s and 1970s. • Phillips curve misinterpreted, as economists overlooked the importance of shifting inflation expectations. • Nominal interest rates wrongly assumed to represent the stance of monetary policy, as economists overlooked the importance of shifting inflation expectations.

13. Milton Friedman brings us “one derivative beyond Hume” • Think of the the Monetary History as a counterfactual history, as if the gold standard did not exist. • Friedman emphasized the importance of inflation expectations, before they became important: • Natural Rate Hypothesis • Fisher effect New Keynesians adopted these two principles, but discarded money supply targeting.

14. Whig View of Monetary History? • Early government initiatives (1918-33): Fed did just enough to get us into trouble, but not enough to get us out. Deflationary bias. • Ad hoc measures to boost gold prices, reduce gold demand (1933-68): Inflationary bias. • Adoption of 100% fiat money, without understanding the implications (1968-81): High inflation. • Taylor Principle (1982-2007): Disinflation, then 2% inflation. Less macro instability. • Zero bound problem: Weak nominal growth (after 2008).

15. The Taylor Principle and the Taylor Rule • Taylor Principle: Raise the nominal interest rate target more than one for one with an increase in inflation (and vice versa.) This is based on Milton Friedman’s work. • Taylor Rule:

16. Specific example of Taylor Rule • r = p + .5y + .5(p – 2) + 2 Where: • r = the federal funds rate target • p = the rate of inflation • y = the percent deviation of real GDP from a target

17. Rules Vs. Discretion • The monetary regime seemed to be more stable prior to 1914 and after 1982. • Monetary policy became more discretionary after 1914, and then moved back somewhat toward a rules-based approach after 1982. • Discretionary policies of 1914-82 created an environment with more cyclical instability, and greater unpredictability regarding the long run path of prices • But is the Taylor Rule the answer?

18. Bernanke’s preferred version of Taylor Rule

19. Bernanke lists 4 weaknesses • Taylor Rule requires policymakers to know the size of output gap. • Taylor Rule requires policymakers to know the equilibrium interest rate. • Taylor Rule requires policymakers to know the optimal coefficients on output and inflation • Taylor Rule provides no policy guidance at zero bound (where guidance is especially needed.)

20. Other problems • Taylor Rule ignores market signals that may provide useful guidance to policymakers. • Taylor Rule gave spectacularly bad advice in 2008. • Tomorrow’s lesson will focus on what went wrong in 2008, and lessons from the Great Recession for the future of monetary policy.