QE
Source: edponsi.com

By Andy Whitford (@abwhitford), University of Georgia

This is an excerpt from Above Politics: Bureaucratic Discretion and Credible Commitment, written with Gary J. Miller of Washington University in St. Louis. This book manuscript is under contract with Cambridge University Press. It is not yet accepted for publication though.

One important legacy of the Great Recession has been that the Federal Reserve expanded the tools in its arsenal for guiding monetary policy by adding “unconventional” policy options like large-scale asset purchases now known collectively as “quantitative easing” (QE). While it will take years for us to fully understand the power of such options, it is clear that QE has changed how we think about the Fed and its role in the American political economy.

On July 10, 2014, the U.S. House Committee on Financial Services held hearings on H.R. 5018, the “Federal Reserve Accountability and Transparency Act of 2014,” a bill sponsored by Representative Bill Huizenga (R-MI):

to amend the Federal Reserve Act to establish requirements for policy rules and blackout periods of the Federal Open Market Committee, to establish requirements for certain activities of the Board of Governors of the Federal Reserve System, and for other purposes.[1]

Dr. John B. Taylor, noted Stanford economist, was the first witness – and for good reason. Taylor was famous for his advocacy of the so-called “Taylor rule,” a view that central banks should tune the nominal interest rate according to a reaction function that depends on important economic conditions like inflation. In a series of papers starting in 1993, Taylor had argued that a policy rule could be devised that allowed the federal funds rate to move as inflation increased above its target or if real GDP increased above its trend – that, “Although there is not consensus about the size of the coefficients of policy rules, it is useful what a representative policy rule might look like” (Taylor 1993, 202). And, he went on at that time to show that a simple rule was a nice approximation of actual policy performance.

Since then, economists have done more than treat this as an academic exercise, with the result that hundreds of papers sought to elaborate what should go into such a rule, the coefficients or weights for those items, the general value of such a rule, and other important matters. Of course, for some, divining such a descriptive model of the Fed’s actions is a way to predict its actions in the future, and so to take positions in the markets that account for that foresight. But for many, taking market positions is not the end-all of the research agenda Taylor started when he tried to describe this “representative rule”. For a number of academic economists and many political interests, the goal was a normative model of Fed behavior – a policy rule that determined the actions the Fed should take (given the data) that would optimize national economic performance.

The proposed bill from Rep. Huizenga would require the Fed to adopt first a policy rule, and second a policy rule against which the first policy rule would be referenced. The second rule would be Taylor’s rule. The Fed would set the first rule, with deviations from Taylor’s rule (and later from the Fed’s own policy rule) allowed only after the Fed Chair testified to Congress.

Much has been written about the Taylor rule and Congress’s intent in pushing legislation to restrain the Fed’s discretion (including effectively outlawing unconventional behaviors like those taken during the Bernanke years amid the Great Recession (e.g., Davies 2014, Nikolsko-Rzhevskyy, Papell et al. 2014, O’Brien 2014). Practically speaking, the push behind this has been “that some members of Congress are seeking to shackle the Fed, not because policy has been too tight, but because they think it has been too accommodative” (Davies 2014). While the rule would allow for the Fed to change, as it sees fit, the way in which data enter its decisions about monetary policy, the real consequence would be that the FOMC “would need to report to Congress after every meeting, allowing for much greater political interference in monetary policy” – for one commentator at least, “This would be a high price to pay for any advantages the Rule might bring” (Davies 2014).

Rules like Taylor’s can have advantages in offering predictability and transparency. But using rules to control the discretion of experienced, professionalized bureaucrats can have a dark side, as well. QE probably had an impact because it was a policy surprise – it did something most of us didn’t think was possible. Some politicians may not like that, but that’s exactly why the Fed has been (and should) remain independent.

References:

Davies, G. (2014). Shackling the Fed with the Taylor Rule. ft.com, Financial Times. 2014. http://blogs.ft.com/gavyndavies/2014/07/13/shackling-the-fed-with-the-taylor-rule/?

Nikolsko-Rzhevskyy, A., et al. (2014). Deviations from Rules-Based Policy and Their Effects. Social Science Research Network.

O’Brien, M. (2014). Republicans Want to Control, not End, the Fed. Wonkblog. Washington, DC, The Washington Post. 2014. http://www.washingtonpost.com/blogs/wonkblog/wp/2014/07/18/republicans-want-to-control-not-end-the-fed/

Taylor, J. B. (1993). “Discretion versus Policy Rules in Practice.” Carnegie-Rochester Conference Series on Public Policy 39: 195-214.

[1] “Federal Reserve Accountability and Transparency Act of 2014”. H.R 5018. 113th Congress, 2d Session (2013-2104). https://beta.congress.gov/bill/113th-congress/house-bill/5018/text. Last accessed on September 9, 2014.

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