An unruly debate over policy rules

George Selgin has a new piece criticizing Narayana Kocherlakota on policy rules. Here’s the intro:

I was just about to treat myself to a little R&R last Friday when — wouldn’t you know it? — I received an email message from the Brookings Institution’s Hutchins Center. The message alerted me to a new Brookings Paper by former Minneapolis Fed President Narayana Kocherlakota. The paper’s thesis, according to Hutchins Center Director David Wessel’s summary, is that the Fed “was — and still is — trapped by adherence to rules.”

Having recently presided over a joint Mercatus-Cato conference on “Monetary Rules for a Post-Crisis World” in which every participant, whether favoring rules or not, took for granted that the Fed is a discretionary monetary authority if there ever was one, I naturally wondered how Professor Kocherlakota could claim otherwise. I also wondered whether the sponsors and supporters of the Fed Oversight Reform and Modernization (FORM) Act realize that they’ve been tilting at windmills, since the measure they’ve proposed would only require the FOMC to do what Kocherlakota says it’s been doing all along.

So, instead of making haste to my favorite watering hole, I spent my late Friday afternoon reading,“Rules versus Discretion: A Reconsideration.”  And a remarkable read it is, for it consists of nothing less than an attempt to champion the Fed’s command of unlimited discretionary powers by referring to its past misuse of what everyone has long assumed to be those very powers!

To pull off this seemingly impossible feat, Kocherlakota must show that, despite what others may think, the FOMC’s past mistakes, including those committed during and since the recent crisis, have been due, not to the mistaken actions of a discretionary FOMC, but to that body’s ironclad commitment to monetary rules, and to the Taylor Rule especially.

The post is much longer and provides a detailed rebuttal of Kocherlakota’s claims. Those who read George know that he is a formidable debater, and I end up much more sympathetic to his view that to Kocherlakota’s view of discretion.  But it’s also important to be as generous to the other side as possible, so that their views don’t seem too outlandish.  Here are two senses in which it might make sense to criticize the Fed for an excessively rules-based approach.

1. One criticism would be that the Fed was too tied to inflation targeting in 2008, when it would have been appropriate to also look at other variables.  In that case, George and I would argue something closer to an NGDP target.  But of course that’s not discretion, it’s a different rule.

2.  Kocherlakota’s main objection seems to be that the Fed put too much weight on Taylor Rule-type thinking. One can certainly cite periods where money was (in retrospect) too tight, especially during and after 2008.  And it’s very possible that the excessive tightness was partly related to Taylor Rule-type thinking.  Thus I would not disagree with the claim that, at any given point of time, the Taylor Rule formula might lead to poor policy choices.

But in the end I don’t find his claim to be all that convincing.  Selgin demonstrates fairly convincingly that while they may have occasionally paid lip service to Taylor Rule type thinking, they were in no sense following a specific instrument rule. John Taylor also makes this argument, and indeed criticized policy for being too expansionary during the housing boom.  I’m going to try to better explain this distinction by reviewing the so-called “monetarist experiment” of 1979-82.

The conventional wisdom is that the Fed adopted money supply targeting in 1979, ran the policy for three years, and then abandoned it in 1982 due to unstable velocity.  As always in macroeconomics, the conventional view is wrong.  Just as wrong as the view that fiscal stimulus contributed to the high inflation of the 1960s, or that oil shocks played a big role in the high inflation of the 1970s, or that Volcker had a tight money policy during his first 18 months as Fed chair. Here’s what actually happened:

1.  The Fed said it would start targeting the money supply, but it did not do so.

2.  The Fed had a stop–go policy in 1979-81, and then a contractionary policy in 1981-82.

3.  Velocity fell sharply in 1982, just as the monetarist model predicts.

The three-year “monetarist experiment” saw inflation fall from double digits to about 4%.  That would be expected to reduce velocity.  Friedman’s 4% money supply rule is supposed to work by keeping inflation expectations stable, so that velocity will be more stable.  But inflation expectations were not kept stable during 1979-82, so the policy was never really tested long enough to see if it works.Having said that, I’d rather not give the 4% money growth rule a “fair test”, as that would take decades, and would probably result in the policy failing for other reasons.  But 1979-82 told us essentially nothing about the long run effect of money supply targeting.  It wasn’t even tried.

In a similar way, the Fed set interest rates far below Taylor Rule levels during the housing boom.  So even if a momentary switch to Taylor Rule policy did occur during the housing bust, it’s not really a fair test of the policy.  It’s be like driving rapidly toward the edge of a cliff, ripping off the steering wheel and handing it to the passenger, and then saying “OK, now you drive”.

Having said that, I also don’t favor the Taylor Rule.  And even John Taylor is open to modifications based on new information as to the actual level of things like the equilibrium interest rate.  When I’ve heard him talk, he’s actually calling on the Fed to adopt some sort of clear, transparent procedure for policy, so that when they make a move, it will be something the markets could have fully anticipated based on publicly available macro/financial data. In that case, I agree, which is why I am more sympathetic than many other economists to what the House is trying to do with its proposed Fed policy rule legislation.

If the Fed won’t adopt my futures targeting approach, then I’d at least like them to make their actual decision-making transparent.  Show us the model of the economy, and the reaction function.  If the model later has to be tweaked because of new developments in macro, that’s OK.  Keep us abreast of how it’s being tweaked.  If FOMC members use multiple models then show us each model, and set the fed funds target at the median vote.  However they make decisions, Fed announcements should never be a surprise.

I’d also like to make a point about “rules” in the sense of policy goals, rather than instrument rules.  People often seem to assume that NGDPLT is a “rule” in the same sense that 2% inflation targeting is a rule.  Not so, NGDPLT is more rule-like that current Fed policy, in two important ways:

1. Any sort of NGDP targeting tells us exactly where the Fed wants the macro economy to be in the future, whereas 2% inflation targeting is much more vague. That’s because the dual mandate doesn’t tell us how much weight the Fed puts on inflation and how much they put on employment.  Even worse, the Fed often predicts procyclical inflation, which would seem to violate the dual mandate.  So it’s not at all clear what they are trying to do.  Should the Fed try to push inflation a bit above 2% during periods of low unemployment, so that it averages 2% over the entire cycle?  I don’t think so, but I have no idea what the Fed thinks, as they don’t tell us.  With NGDP targeting it’s clear—aim for countercyclical inflation.

2.  Going from NGDP growth rate targeting to NGDPLT, also makes policy much more rules based.  Under NGDPLT, I have a very good sense of where the Fed wants NGDP to be 10 years from now.  That helps us make more intelligent decisions on things like determining the proper yield on 10-year corporate bonds. If they miss the target on a given year, I know that they will aim to get back onto the old trend line.  In contrast, the Fed currently doesn’t have any clear policy when they miss the target.  Are they completely letting bygones by bygones, or do they aim to recover a part of the lost ground?  I have no idea.  It seems to vary from one business cycle to the next.  In 2003-06 they regained ground lost in the 2001 recession, but in 2009-15 they did not do so.

I certainly also favor a policy rule for the instrument setting, but even if the instrument setting were 100% discretionary, I would view NGDPLT as an order of magnitude more rule-like than a “flexible” 2% inflation target, which also takes employment into account.



21 Responses to “An unruly debate over policy rules”

  1. Gravatar of Iskander Iskander
    25. September 2016 at 15:37

    Prof Sumner,

    This is kinda off topic, but relevant to what you have been saying since 2009.

    I am an economics undergraduate at a UK University and I have been assigned an “online text book” called “core-econ”. It’s catchphrase is “teaching economics as if the last three decades had happened”.

    I looked at the chapter on inflation and it says that the cause of inflation is employer-employee conflict (“Inflation results from conflicting and Inconsistent claims on output”).It then discusses shocks (oil shocks) that have a one time effect on the price level, but absolutely nothing about the quantity theory of money. More said about power plays than printing presses.

    When it comes to monetary policy, it suggests that it only acts through the exchange rate channel (“increasing international competitiveness”) and decreasing interest rates. Absolutely nothing about the excess cash balances channel.

    When it gets to getting out of the great depression it suggests that fiscal policy played the main role (Doesn’t a paper by Romer suggest that it was almost entirely through monetary means that the US got out of the depression. Not to forget your own work as well).

    Is this not a return to the economic stone age? It does seem that what you have been saying is true, that the economics profession (at least at my uni) has reverted to vulgar Keynesianism and has forgot the lessons of the past 30 years.

    What can one do? Buy copies of the “Monetary History” or your book and throw them around campus?

    Perhaps I am being foolish/arrogant, this is an econ 101 course after all.

  2. Gravatar of dtoh dtoh
    25. September 2016 at 19:27

    As I have said, it’s a bunch of stupid people in a room making wild ass guesses until it’s time to go home for dinner and then they agree on the last thing that was proposed.

  3. Gravatar of Gary Anderson Gary Anderson
    25. September 2016 at 21:30

    The only bonds that are under subscribed are from Africa. So, demand for corporate bonds is massive. How will that change based on anything the Fed can do?

    Fricken Spain sells a 50 year treasury 3 times oversubscribed. Argentina bonds are almost 3 times oversubscribed.

    So, people look around for corporate bonds if treasuries are sold out. How will that change? I don’t think it can, IMO.

  4. Gravatar of ChrisA ChrisA
    25. September 2016 at 22:19

    Seems to me that, by the bureaucratic calculation, the Fed should be happy to follow an iron rule. Then they can’t be blamed for any problems. But by the same bureaucratic calculation, don’t expect them to introduce any such rule, since they then would be accountable for the success or not of it. The Fed best bet in such a climate is to be as obfuscationary as possible about what they plan to do, leaving room at all times to blame “unforeseeable factors” for any problems. Which is what we see.

    The lobbying for a new rule for the Fed to follow therefore needs to come from politicians. The problem for any politician with a serious chance of become elected is that such ideas as NGDP targeting seem outlandish, sort of heterodox. So wanting to be seen as “serious people” they stay on the safe side, as anyway almost no electors really understand how important this issue is. So I am afraid there is nothing for it but to slog out this idea in academic circles, gradually winning the argument one step at a time, and letting to the older guys gradually die off or retire, until NGDP finally becomes respectable.

  5. Gravatar of Ray Lopez Ray Lopez
    25. September 2016 at 22:41

    Happily, none of this matters as the SRAS curve is very steep (money is largely neutral). It’s weird that Sumner refers to high inflation of the early 1980s rather than the liquidity trap of today as an example on monetary success. According to monetary theory, SRAS is more easily ‘made flat’ by restricting the money supply (i.e., what Volcker allegedly did) than if SRAS is almost flat, such as at the low-inflation zero bound, where SRAS is already flat. Sumner conflates the zero bound with high inflation. What is Sumner’s proposal for getting out of the zero bound? I hear crickets… yes, he’ll say ‘adopt my NGDPLT’ but that’s like saying ‘appoint Ray Lopez as emperor and he’ll solve anything’–perhaps true, but magical thinking and metaphysics. Still, I like Sumner as he tilts at windmills and that’s heroic.

  6. Gravatar of Bryan Atkins Bryan Atkins
    26. September 2016 at 04:31

    Think we’re beyond policy; our problems are deeper and more fundamental.

    And that if you’re going to write rules re monetary policy, then economists should place / consider code, including monetary code, in a physics / evolution / complexity context. They don’t. Think this foundation error largely blows up the field: economics.

    Here’s one fundamental problem.
    We’re in Anthropocene.
    Part of that: Human cultural selection increasingly drives natural selection.
    Part of that: We’re increasingly doing natural selection with world culture’s dominant code for relationship / reality interface: monetary code.
    FAIL. Exhibit A: Sky. Exhibit B: Ocean.
    Culture, Complexity & Code:

  7. Gravatar of ssumner ssumner
    26. September 2016 at 05:25

    Iskander, I feel your pain, that sounds like a horrible book.

    ChrisA, You said:

    The lobbying for a new rule for the Fed to follow therefore needs to come from politicians.”

    I think it needs to come from the economics profession, the same place the current inflation targeting rule came from.

    Ray, You’ve been exposed on money neutrality. Time to man up and admit you lost. Nobody likes a poor loser.

    Bryan, You said:

    “Here’s one fundamental problem.
    We’re in Anthropocene.”

    Do you think NGDPLT would work better in the Pleistocene than in the Anthropocene?

  8. Gravatar of dtoh dtoh
    26. September 2016 at 06:11

    Just one thought here. Maybe the problem is that NGDPLT sounds unfamiliar to many people. So maybe you should be pushing instead for a policy rule of LT for real growth plus inflation of 4.5%. In other words drop NGDP from your lexicon and start referring to a combined growth plus inflation target….Easier for the masses to understand. Even Trump would understand it :-).

  9. Gravatar of flow5 flow5
    26. September 2016 at 06:29

    N-gDp targeting maximizes inflation and minimizes real-output.

    That’s some policy Scott.

    True: Monetarism as never been tried. And Dr. Richard Anderson covered his “elephant tracks”.

    See: Paul Meek’s description of how the FRB-NY’s “trading desk’s” used repurchase agreements (and reverse repurchase agreements), in his 1974 booklet: “Open Market Operations”.

    Therein, he described the same modus operandi that Paul Volcker supposedly first tried in 1979 (targeting non-borrowed reserves). So nothing’s changed since William McChesney Martin, Jr. changed from using a “net free” or “net borrowed” reserve position approach – to the Federal Funds “Bracket Racket” c. 1965 (using interest rates as its monetary transmission mechanism).

    “1.One criticism would be that the Fed was too tied to inflation targeting in 2008, when it would have been appropriate to also look at other variables.”

    That’s how dove / hawk schizophrenia works, viz., because of increasing stagflationary pressures. During a “FED induced cycle”, interest rates are allowed to rise. This eventually results in more savings (and the proportion of TDs to DDs), being impounded within the commercial banks (thereby slowing non-bank money velocity). Thus, the FED, using Scott Summers’ guidelines, increases the inflation component (exacerbating this condition).

    The proper policy is the same one that was used to combat dis-intermediation (and the subsequent declining economic activity), during the 1966 S&L credit crunch.

    – Michel de Nostredame

  10. Gravatar of ssumner ssumner
    26. September 2016 at 06:45

    dtoh, You said:

    “start referring to a combined growth plus inflation target….Easier for the masses to understand.”

    Just the opposite:

    1. The public understands the concept of getting a 4.5% raise from their boss. They don’t understand that they got a 2.5% real wage increase plus 2% inflation. Indeed many workers would prefer a 4% raise in a year of 5% inflation, over a 1% pay cut in a year of 1% inflation. Money illusion.

    2. I’m not trying to convince average people, who have little say over monetary policy. I’m trying to convince my fellow economists, and other influential pundits.

    Why would I care what Trump thinks about monetary policy? Did Obama’s views matter?

  11. Gravatar of Alexander Hamilton Alexander Hamilton
    26. September 2016 at 07:40

    Iskander, Good god that book sounds awful. I understand why academic freedom in research is important but there really should be some kind of oversight when it comes to teaching. I know is some universities it is the department that sets the core text and not just the course co-ordinator. Anyway, read his book and pass his class. Just remember that what he’s teaching goes against the overwhelming academic consensus.

  12. Gravatar of George Selgin George Selgin
    26. September 2016 at 08:37

    Thanks for the commentary, Scott. I agree that Kocherlakota would have had a valid point had he limited himself to claiming that the Taylor Rule isn’t always an ideal guide to monetary policy. But of course, he went much further, by exaggerating the extent to which Fed actions conformed to that rule, and in confusing voluntary reliance of any sort on a rule with rule-based policy in the strict sense of the term.

    I also agree with you that it is more accurate to say that the Fed erred by placing undo emphasis on inflation targeting than to claim it did so because it was inclined to follow the Taylor Rule.

    In short, both proponents of NGDP targeting and those who favor the Taylor Rule itself have reason to say that the Fed’s misconduct was due, not to its adherence to any well-considered rule, but to its misuse of its discretionary powers. The FOMC thought it could do better than either (1) the Taylor Rule or (2) NGDP targeting. Instead, it did (1) worse and (2) much worse, respectively.

  13. Gravatar of dtoh dtoh
    26. September 2016 at 09:04


    You said, “Why would I care what Trump thinks about monetary policy? Did Obama’s views matter?”

    He didn’t have a view because economists were inept at explaining it to him.

    You also said, “Indeed many workers would prefer a 4% raise in a year of 5% inflation, over a 1% pay cut in a year of 1% inflation. Money illusion.”

    Bad question and bad example. Workers don’t know inflation in advance. They know a wage cut when they see it. If you asked the common sense question…”Would you prefer to have pay adjusted to 1% over the inflation rate or 1% under the inflation rate…. there would be no false ambiguity.

    Did you ever ask why you haven’t convinced all the other economists yet. 1) Are they all dumber than you? 2) Are you wrong? Or… 3) Is there another reason? (Serious question. I’d like to know what you think the reason is.)

  14. Gravatar of Gary Anderson Gary Anderson
    26. September 2016 at 09:39

    2. I’m not trying to convince average people, who have little say over monetary policy. I’m trying to convince my fellow economists, and other influential pundits.

    I don’t think economists have much influence over monetary policy either. 10 year down to 1.584 percent yield. That was the shortest tantrum in the history of history.

    The structured finance totalitarian system we have makes economists pretty much useless. Maybe they could become bankers or something.

  15. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    26. September 2016 at 12:13

    ‘Did Obama’s views matter?’

    Probably his ignorance of monetary theory explains why he left those seats open.

  16. Gravatar of Jim Glass Jim Glass
    26. September 2016 at 17:30

    1. The Fed said it would start targeting the money supply, but it did not do so …. 1979-82 told us essentially nothing about the long run effect of money supply targeting. It wasn’t even tried.

    I don’t understand you here. Certainly money supply targeting wasn’t tried over a long run, so one can’t see any long-run effect of it. But why do you say money supply targeting wasn’t adopted at all?

    Volcker in his 1992 memoir “Changing Fortunes” explained why the Fed in 1981 had to change policy to money supply targeting from interest rate targeting, and went into considerable detail about the political resistance from the Reagan Administration that he had to overcome to do it, and the political ploys he used to do so. I don’t see why he’d make up such a detailed story about something that never happened.

    Plus, looking at the M1 numbers for the period from Fred, one sees that after rising steadily pretty much from beginning of time, M1 peaked at $429 billion on 4/20/81, three months before the start of the recession, then went down a little bit, then bounced down a tiny tad and back up again repeatedly to hit pretty much exactly $429b again on 7/6, 8/10, and 10/12 thru 10/26 without ever going at all over $429b (or going below $423b). So on the dates three months before the recession started and then three months after it started, M1 was $429b, exactly unchanged. If the money supply wasn’t being targeted during that period, all those $429b numbers are a heck of a coincidence.

  17. Gravatar of Ray Lopez Ray Lopez
    26. September 2016 at 22:19

    @ssumner – I was not ‘exposed’ on anything. I simply misunderstood the SRAS curve on money neutrality. Now that I’ve been corrected, thanks to you, I say it’s very steep. You say it’s not. What is your evidence? It’s not observable. Have you read Paul Romer’s blog and criticisms lately? You should do an article on it. But religion is a powerful force and I doubt you change your mind. I once believed in monetarism until I saw the evidence and changed my mind. What do you do sir?

  18. Gravatar of ssumner ssumner
    27. September 2016 at 06:38

    George, Good points.

    dtoh, You said:

    “Did you ever ask why you haven’t convinced all the other economists yet.”

    Same reason you haven’t. It’s hard to convince people.

    Did you every wonder why more economists have converted to NGDP targeting over the past 10 years than anyone in their right mind would have dreamed possible back in 2006? Must be because I am using the wrong arguments.

    Jim, I’ll do a post.

    Ray, No, you told me you think a demand increase would boost output. That means you think money is non-neutral. Now you are backing off to try to save face, but your entire worldview is a garbled bunch of nonsense, there is no there there. It’s meaningless to talk about what Ray believes, as he doesn’t even know enough to hold a belief.

  19. Gravatar of Gabe Gabe
    27. September 2016 at 09:27

    I don’t believe they will make their “model” transparent for very sound reasons. It is completely off the table.

    The Fed makes it’s decisions through some secretive top down approach…either under coordination from the super secretive BIS or through the high end finance executives like Goldman Sachs/JP Morgan CEOs that they constantly talk to in secret conversations….the elite string pullers do some petty things like front run….but they also like to create crisis moments for other highly strategic reasons that are very useful for their larger policy objectives and the manipulations of the masses.

  20. Gravatar of H_WASSHOI (Maekawa Miku-nyan lover) H_WASSHOI (Maekawa Miku-nyan lover)
    27. September 2016 at 21:31

    Abe’s brain knows NGDPLT.
    However, no big country has adopted NGDPLT yet explicitly.
    It is hard to persuade conservative Japanese politicians to adopt NGDPLT.
    (because also it is not the global standard)

    Japan has
    Overshoot commitment+Abe’s 600 trillion NGDP target
    [+QQE+Yield Curve control(driven by economic circumstance)+buying assets.
    +pension funds’ asset buying is a option. ]

    US has
    2% ceiling IT(it seems) +blah blah blah
    +Presidents have no idea about MP(including next president,it seems)

    lack of credibility? Baghdad Bob?
    Which one?

    Anyway, both need NGDPLT MP framework (or NGDP futures)

  21. Gravatar of dtoh dtoh
    29. September 2016 at 16:05

    @scott Sorry for the late reply. You have convinced a lot of economists… fine….but you haven’t convinced enough by far. You need to think about your message. If you give someone like Bernanke “above average” marks for his tenure at the Fed, then no one is going to listen to you. The guy was an utter failure (unless you consider 10 of millions of people out of work a success). You know and I know that with NGDPLT, this could easily have been avoided.

    Also I would stop diluting your message with all the political posts.

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