A Work Around for the Fed's Knowledge Problem

Ramesh Ponnuru has a new article titled Fallible Fed Needs a Few Good Rules. Here is an excerpt:

Some Republicans think that Congress should supply a framework for the Fed, making it more rule-bound. One much-discussed approach would have the Fed follow the “Taylor rule” -- named after John Taylor, a Stanford economist -- which says that the federal funds rate should be set according to a formula involving inflation, the long-run real interest rate, and the gap between the economy's actual output and its potential output. The Fed’s behavior might then be more predictable. It would raise and lower the fed funds rate according to the formula.

The Economist magazine recently criticized the idea of following a formula, arguing that the Taylor rule has drawbacks. It argued that the Fed should continue to exercise broad discretion over monetary policy.

But to say that a central bank acting on its own discretion could perform better than one following the Taylor rule doesn't mean that it is likely to do so. And the Taylor rule isn't the only possible rule. The Fed could instead act to keep the growth in nominal spending -- the total amount of dollars being spent each year on consumption and investment -- at a fixed percentage each year. That approach wouldn't require it to make confident estimates about the output gap or [equilibrium] interest rates. It would also lend itself to greater predictability, and a recent paper suggests that it might work better than either inflation-targeting or the Taylor rule, especially given uncertainty about those values.

Ponnuru alludes to an important point in the paragraph above. Monetary policy suffers from the knowledge problem. Monetary authorities simply do not know enough about the economy in real time to make informed decisions. And this is not just a problem with theoretical Taylor Rules. It is a problem for modern central banking. One area, in particular, where they have a hard time is knowing how to respond to supply shocks. They are challenging since they push output and inflation in opposite directions and have plagued central banks in advanced economies over the past decade. As I noted earlier:

Supply shocks were an issue in 2002-2004 when the much-ballyhooed productivity boom (a positive supply shock) of that time made Fed officials worry about deflation. They consequently kept interest rates low even though the housing boom was taking off. Supply shocks were also an issue in the fall of 2008 when Fed officials were concerned about rising commodity prices (a negative supply shock) and, as a result, decided to do nothing at their September FOMC meeting despite the collapsing economy. 

Across the Atltantic, the ECB has struggled even more with supply shocks. The ECB raised interest rates multiple times in 2008 and 2011 in response to the commodity price shocks (negative supply shocks). Below is a figure from a Robert Hetzel paper on this crisis that shows how misguided the rate hikes were. They occurred even though spending was already falling. It is no wonder the Eurozone has struggled so much since 2008.

One can trace this wrinkle back further. Ben Bernanke, Mark Gertler, and Mark Watson argue the reason oil supply shocks have historically been tied to subsequent weak growth is not because of the shocks themselves, but because of how monetary policy responded to those shocks. That is, central banks typically responded to the inflation created by the supply shocks in a destabilizing manner. With the advent of inflation targeting in the early 1990s, this wrinkle has become institutionalized across most central banks.

Now in theory modern inflation targeting should be able to handle these shocks. For the modern practice is to do 'flexible inflation targeting' which aims for price stability over the medium term and therefore allows some wiggle room in responding to supply shocks. The problem, as demonstrated above, is that in practice it rarely works. Responding to supply shocks in real time requires exceptional judgement and usually some luck. In fact, as I note in this policy paper, some scholars think that the successes of inflation targeting prior to the crisis were due largely to luck. There were simply fewer supply shocks during the early years of inflation targeting.

Ironically, The Economist article Ponnuru mentions above argues discretion is preferred because of the knowledge problem! It says that "until the day the economy is fully understood, human judgment has a crucial role to play." Really? It would seem the last eight years of ad-hoc, make-it-up-as-we-go-along policy by the Fed and ECB would give pause to this type of thinking.  Especially with the weak recoveries these responses have created.

As Ponnuru notes, one of the big appeals of a nominal spending target rule is that it gets around the knowledge problem. Under this rule the Fed would simply stabilizes the path of total dollar spending.  There would be no need to worry about changes in the real economy. If for example, there were a positive supply shock—say new technology or increased oil supply—that lowered prices the Fed would do nothing other than maintain stable money spending. The composition of the spending would change—more goods and services at lower prices—but the total amount of spending would not. Likewise, total dollar spending would not change if there were a negative supply shock—such as a natural disaster or an oil shortage—though its composition would alter too.  In other words, the Fed would let relative prices and markets sort out real shocks on their own while maintaining monetary stability. This means the knowledge problem would no longer be a constraint in implementing monetary policy. This is just another reason for the Fed to adopt a nominal GDP target rule.