Episode 23 - The Rules, Part I
How a simple math equation became one of the largest debates in Monetary Policy at the Federal Reserve and Central Banks around the world. Today’s episode in two sections: (1) How is monetary policy currently decided? And (2) What is a policy rule?
Welcome to The Bankster Podcast. I’m your host, Alexander Bagehot. Every episode we dive into what I call The Centralverse! The incredibly fascinating and ever more consequential world of central banking. This is Episode 23 - The Rules, Part I.
I am quite excited about today’s episode. We are going to talk about, arguably, the most important role and definitely the most visible role of the Federal Reserve. We’ll also scratch the surface of one of the most striking debates in the modern Centralverse. The topic - setting monetary policy. This discussion could go on for days, dissertations could and have been written on the topic, and literally entire careers have been spent studying it. But The Bankster Podcast’s goal is to give you a healthy, solid foundation of monetary policy and the men and women that make it, and today’s episode is no exception.
By the end of the episode you will have all you need for a great start on the topic of setting monetary policy. Instead of the traditional news/history sections we will split the episode into two sections - two questions: (1) How is monetary policy currently decided? And (2) What is a policy rule? And before we dive in let me just give you a brief overview of why I decided on this topic for today’s episode.
Two weeks ago Janet Yellen took a trip back to her old stomping grounds. As some of you may know or remember, before joining the Board of Governors as Vice Chair in 2010, she was known as President Yellen, President of the San Francisco Fed that is (in that position from 2004-2010). She also spent time as a professor at the University of California at Berkeley. So while enjoying a return to familiar land, Chair Yellen gave two speeches. Both were good speeches and I recommend the hard-core Fed watchers check them out. But the second speech specifically was what caught my attention. At this speech, given at the Stanford Institute for Economic Policy Research, her focus was how the actual monetary policy actions taken over the last few years differ from policy actions that a set of different “rules” would have recommended.
John Taylor (more to come on him in the next episode) was in the audience, and he asked a good question that sparked an intriguing back-and-forth about monetary policy rules. As I was listening to the exchange, I realized that in order to understand the current Centralverse - you need to understand the idea and a few key people behind monetary policy rules. Today we will start that discussion.
How does monetary policy work now?
For starters, the idea of implementing a monetary policy rule, implies that currently there is no rule. And that is sort of true, the dictionary defines a rule as, “one of a set of explicit or understood regulations or principles governing conduct within a particular activity or sphere”. There has been no law passed by the House and the Senate and signed by the President that forces the Federal Reserve to set interest rates based on a rule. So how does the policy actually get made? Who makes these decisions?
Well, if you’re a loyal listener to The Bankster Podcast you’ll be able to answer that question easy-peasy. The Federal Open Market Committee (the FOMC) is the group that decides what the monetary policy will be for the country. We have gone over in detail the structure and voting system of the FOMC in previous episodes. In fact I dedicated two early episodes completely to this group, head back to Episodes 3 and 5 to check them out.
But for today’s episode’s purpose we are going to focus on the actual decision making process of this committee. The 19 members (with the usual disclaimer - when the Board of Governors is fully staffed), each attend all of the meetings of the FOMC. At these meetings 12 of the members get to vote. In preparation for the meeting all of the members have been briefed about the current economic conditions of the national and international markets and economies. They also have access to government statistics and business surveys. The Board of Governors employees over 300 economists. Each Reserve Bank also has a few dozen economists. These economists are studying the economy and trying to model it as best they can.
So the members of the FOMC have access to a lot of information and are surrounded by a very well educated and highly diverse group of people. These members also have their own sets of opinions and contacts that they are reviewing.
But when judgement day comes - about every six weeks for the Federal Reserve - and the FOMC members meet in the grand conference room of the Eccles Building on Constitution Avenue, the monetary policy is set by a simple vote. Each of the voting members can vote however they would like. They do not have to explain their vote (although they often do in speeches and at conferences) - but they are not required to explain it. And on an even deeper level, the voting members are not even required to describe what process they went through in doing their research. Each voting member is free to vote to increase interest rates or lower them as they see fit. Period.
So that’s how monetary policy is currently decided. A lot of people spend their days studying and analyzing the economy. They share that information with 19 people. 12 of those people then get to vote however they would like. Raise interest rates, lower them, or leave them be.
As you’ve been listening I’m sure you’ve thought of a few questions. Among them, you may be wondering, why does it work like this? Well, the simple answer is that the government wanted the monetary policy decisions to be made without restraint or hindrance. Bureaucracies are infamously slow. Politicians crafting the Federal Reserve Act (and its subsequent amendments) wanted the country’s central bank to be able to respond quickly and precisely to the swings in the economy. In 1935 they defined this by the creation and voting standards of the FOMC.
I began this section of the podcast by sharing the dictionary definition of “rule”. The definition mentions “explicit or understood regulations or principles governing conduct”. We’ve now established that there are neither explicit nor understood rules governing how the FOMC members vote on interest rates (monetary policy).
But this sparks the question, What’s the alternative? Is there another way to make monetary policy decisions? What might an explicit monetary policy rule look like? Let’s dive into our next section to answer these very questions.
What is a monetary policy rule?
Making one of the original references to a modern monetary policy rule, Milton Friedman said, “The conclusion I have reached on the basis of both the past and recent records is that money is too important to be left to central bankers.” Friedman, the famous professor from the University of Chicago, a Nobel laureate and one of the most influential economist of all time, made that claim back in 1959 at a university lecture series. Friedman continued, “I come to the conclusion that there is only one other alternative. That is to adopt some kind of rule which will guide our monetary managers, the [Federal] Reserve System…”.
This speech and Friedman’s subsequent book sparked the idea of the modern monetary policy rule. The debate has continued ever since. Now you may be saying to yourself, but Alexander, we have yet to define what a monetary policy rule even is. And you’d be correct. I’m actually going to let Professor Friedman tell you about his rule. Then we’ll break it down on a more general level.
“I am led to suggest as a rule the simple rule of a steady rate of growth in the stock of money [podcast listeners, stock of money simply means the supply of money, or in other words, the amount of money in the economy]” Back to Friedman, “that the Reserve System be instructed to keep the stock of money growing at a fixed rate, 1⁄3 of 1% per month or 1/12 of 1% per week, or such and such a percentage per day. We instruct [the Federal Reserve] that day after day and week after week it has one thing, and one thing only, to do and that is to keep the stock of money moving at a steady, predictable, defined rate in time.” (source)
I don’t know about you, but that is about as explicit as it gets. Under Friedman’s rule, the Federal Reserve would decide monetary policy by simply increasing the amount of money in the economy by a, as he put it, “steady, predictable, defined rate”. That’s the purpose of a monetary policy rule, in its simplest form, a rule takes away the human side of the decision making process. No longer would the 19 members of the FOMC have to gather together to decide what the Federal Funds rate should be. Instead, they would simply change the supply of money in the economy by the predetermined amount set by the rule. Interest rates would float with the movements of the markets.
Now let’s take a step back from Friedman’s rule because dozens upon dozens of monetary policy rules have been used and proposed throughout the history of the Centralverse. On this episode I’ll introduce you to two other famous rules or genres of rules.
For centuries the favorite rule involved gold. Empires rose and fell with the level of their stock of gold. The government and banks created money based on how much gold they had on reserve. The money, often in paper notes, could be taken to a bank and exchanged for gold, based on some rate, say 50 English Pounds for an ounce of gold or 100 English Pounds for two ounces of gold.
And although you might think of the word stable when you hear the word “rule”, the level of a gold was anything but stable. The amount of gold that was held by the empire would sometimes rise dramatically if new sources of gold were found, whether from wars and plunders or new mine deposits. But then there would be seasons where the money could not expand because no new gold was introduced to the economy.
In some future episode we’ll talk more about the gold standard. But for now, I think you understand the basics. And going forward when you hear people talking about the “Gold Standard” or “A Return to the Gold Standard” you’ll know that they, whether they know it or not, are referencing an old and volatile monetary policy rule.
One final type of rule that I’ll mention today takes the idea behind the gold standard rule and takes it one step further. I am referring to Monetary Rules based on mathematical formulas. You can imagine that the Gold Standard was a very simple formula like I mentioned before. 50 Pounds equaled one ounce of gold.
Although the Gold Standard proved ineffective and counterproductive for the economy, many economists began to wonder if the problem with the Gold Standard wasn’t that it was a simple formula, but that it wasn’t using the right inputs. That’s where we get to the Monetary Policy by Mathematical Formula rule.
There are dozens of these formulas. The most famous of which is called the Taylor rule. Ok, now I’m sure many of you may hear mathematical formula and cringe, but stick with me, this not complex. I’m going to explain a quick principle of a mathematical formula and then I’ll talk it through. A formula has two sides, separated by an equals sign. On one side you have your inputs. The other side contains the output. You can imagine it’s like following a recipe. All of your ingredients are on one side, arranged in a certain way, and on the other side is the result. For baking, it might be a cake.
For monetary policy rules, the ingredients are economic indicators or statistics about the economy - those are the inputs. Then on the other side of the equation is the result - and in this case the result is the desired monetary policy action.
So let’s take Taylor’s Rule as an example. The inputs for the Taylor rule include: current inflation, desired inflation, current GDP, and potential GDP. On the other side of the equation, the output, or the result is the rate at which the central bank should set the interest rate.
Can you feel the spirit of what Friedman was talking about. Federal Reserve leaders would still have to use their judgement. They’d have to decide what they believe the desired inflation rate is and what the potential GDP of the country is, but those would be the only two decisions. After that they’d drop the numbers into the formula and out would pop the monetary policy decision.
Ok, you know what? The original plan for this episode was to now jump into the man behind the Taylor Rule, but I have already shared a good amount of material and I have too much left to cover for this one episode. So I’m going to leave it here for today. We learned how monetary policy decisions are made now; we learned what monetary policy rules are; and we even discussed a few of the most famous rules. On the next episode I will introduce you to John Taylor. I will also introduce you to a bill that has been passed by the House of Representatives, but never by the Senate, so it isn’t a law. But it might get some new light with the Republicans in charge of the Senate, the House, and the White House. It’s a very interesting bill that is all about monetary policy rules. I’m excited to share it with you.
So that’s a quick preview of what to expect coming your way in two weeks.
As always, feel free to drop me a line with comments and questions about the Centralverse or the Bankster Podcast via email (firstname.lastname@example.org) or Twitter or Facebook.
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Today’s episode was written, edited, and produced by me, Alexander Bagehot. I dedicate this episode to the late Milton Friedman - you changed the Centralverse forever. To the rest of you, thanks for listening! I’m Alexander Bagehot, and I’ll see you next time on The Bankster Podcast!