Would you be happy if the cabin crew announced that the plane you were about to take off in had no pilot, and was going to be flown solely on autopilot? My guess is no.
Even though flying is a fairly routine and mechanical process, you still need the peace of mind that a human – with training, intelligence and, most importantly, intuition – will be on hand to intervene and deal with any unforeseen turbulence or technical issues.
With the US Federal Reserve meeting today, with the possibility of a September interest rate rise high on the agenda, it is worth remembering that central banking is no different. Contrary to popular belief, it is more of an art than a science. Its subtleties and nuances are far too complex for pre-determined rules to be applied.
Unfortunately, some members of the US Congress are currently struggling to realise this. Perhaps the most interesting part of Fed chair Janet Yellen’s recent testimony to the House Financial Services Committee were questions over the proposal to create a policy rule enshrined in law, billed as increasing transparency.
The idea is that the Fed is forced to follow a particular rule, essentially formalising the way it shapes policy in response to incoming information about the economy. The Fed’s behaviour could then be assessed against this rule and Congress could hold the central bank to account for any deviations. In theory, this should lead to more predictable behaviour, resulting in better and less volatile economic outcomes.
There is nothing new about the idea of monetary policy broadly following a rule. Famously, John Taylor showed that Fed policy tended to follow a relatively simple rule linking the policy rate to inflation and the output gap. There is now a whole family of “Taylor rules”, all with subtly different terms that purport to describe central bank behaviour, and such rules do tend to make monetary policy more predictable.
So much for the theory. In practice, making the Fed follow any particular rule would be a terrible policy mistake. To start with, note that Taylor was initially seeking to describe Fed policy not prescribe optimal policy. Indeed, we simply don’t know which particular rule would be optimal in all circumstances, so to choose one over another already introduces discretion and judgement into monetary policy, which is precisely what Congress is trying to avoid.
In fact, it would be impossible to remove discretion even once a rule was in place. Central bankers have to weigh numerous elements that can’t be directly observed, like the size of the output gap, the equilibrium interest rate, and the level of full employment. All of these elements require judgement based on experience and intuition. There is no magic rule that can tell policy-makers exactly what to do in all situations. Discretion-free central banking is simply impossible. Relatively predictable policy is the best we can hope for, but that should involve systematic policy-making, not automatic rule following.
So there is very little economic justification for such legislation. Instead, its attraction to Congress seems to be that it would allow it to interfere more in the Fed’s decision-making, second-guessing and even manipulating its behaviour. History tells us that such political control of monetary policy rarely ends well.
We still unreasonably expect central bankers to make perfect decisions based on imperfect information. A giant stick from Congress might just make those decisions even harder to make.
Legendary French chef Auguste Escoffier, while not known for his central banking prowess, somewhat surprisingly provides us with some insight: “No theory, no formula, and no recipe can take the place of experience.”