The US presidential candidates have not missed the opportunity to question the power of the Federal Reserve (Fed) and the independence of its monetary policy. The 2015 Federal Reserve Transparency Act, designed to hold the Fed accountable for its actions and make it adopt a clear, predetermined rule for setting its key interest rates, is currently in the hands of the Senate. The proposed rule is an equation indicating the adjustment to be made to the federal funds rate, at any given time, depending on changes in inflation and economic growth. The famous Taylor Rule, to which the Fed occasionally refers, deals with this subject. The bill before the US Senate marks a reaction to the zero interest rate policy which the Fed pursued from 2009 to 2015 and which deviated considerably from the interest rate recommended by the Taylor Rule (see chart below and box on p.4).
The two schools
The debate is nothing new. Two schools of thought have opposed each other for years regarding what they see as the optimal method for achieving the price stability and full employment objectives that comprise the Fed's mandate. Should the US central bank be using a discretionary policy like the one it pursues now or should it follow a stricter mathematical formula instead?
- Some think that following a Taylor-type rule is a simple, transparent method that consumers, companies and investors could easily understand. It would enable them to anticipate the Fed's monetary policy and thus prevent uncertainty. This school accuses the Fed of straying too far from the optimal rate measured by the classic Taylor Rule and thus of having been too accommodative for too long after the financial crisis.
- Others think that a method like the one currently used by the Fed, which includes a qualitative judgment by the governors, is more flexible and therefore better suited to the cyclical nature of the American economy. It allows the Fed to react to economic data and the expectations of economic agents. Though less foreseeable for the markets, it confers greater independence on the Fed governors and enables them to respond to crises better.
Why has Fed policy deviated from the Taylor Rule?
Based on growth and inflation data, the Taylor Rule has recommended a federal funds rate of about 2% since 2011, well above the zero rate set by the Fed (see chart on p.3). Even though former Fed Chairman Ben Bernanke succeeded in devising a modified Taylor Rule, recommending a rate below zero between 2009 and 2015 (see left-hand chart on following page), the Fed mainly used its discretionary power to set monetary policy during that period.
Some factors actually argue for a higher federal funds rate:
- The core inflation rate, which excludes food and energy prices, has been around 1.5% a year since 2009 (see right-hand chart on following page). That is below the Fed's 2% target, but not far enough below to justify zero interest rates.
- Real GDP has risen by roughly 2% a year on average over the same period, in line with its new potential rate (see chart above), requiring a higher key interest rate than the one set by the Fed.
But the monetary policy pursued by the Fed until end-2015 was justified by many other factors that are not included in the Taylor model.
- First of all, the US economic recovery would not have been as strong if the Fed had not kept interest rates at zero and had not introduced quantitative easing (QE) over that long period. Moreover the frequent changes to the federal funds rate recommended by the Taylor Rule deterred the governors from following it.
- Given the unprecedented scale of the financial crisis, Bernanke did everything in his power to eliminate systemic risk and prevent Japanese-style deflation compounded by recession. Ultra-accommodative monetary policy over a protracted period seemed the only answer.
- It took time for the US labour market to firm up again. The unemployment rate did not fall back to its pre-crisis level until last year (see left-hand chart on previous page). Wage growth was stagnant and the US working population shrank significantly (see right-hand chart on previous page). Until end-2015 the Fed did not want to raise rates in view of the persistently low utilisation of labour.
- The US consumer credit market struggled to recover after the subprime implosion. Initially only non-financial companies and state governments started borrowing again (see left-hand chart below). Households and financial institutions still lacked confidence. The devastated mortgage industry likewise went through a painful process of adjustment.
Since last year, however, the US labour and credit markets have improved considerably. Job creation is robust again and mortgage lending is increasing (see right-hand chart below). But while these developments explain why the Fed started normalising its monetary policy in December, they do not warrant a quick alignment of the federal funds rate with the Taylor Rule. The Fed's policy committee still disagrees on the domestic economic outlook and the present international environment does not call for aggressive monetary tightening.
The Fed should continue to rely on the qualitative judgment of its Open Market Committee to set monetary policy. Forcing it to follow the Taylor Rule in lock-step, for the sake of greater transparency, could turn out to be counter-productive. Concessions by Congress will therefore be necessary to preserve the central bank's independence, an essential prerequisite for the long-term stability of the American economy. Since the onset of its current tightening cycle, the Fed has used its discretionary power wisely. When the markets reeled in January and February, the dollar shed 3.7% of its value, the S&P 500 finally steadied and the 10-year Treasury yield fell from 2.3% to 1.7%.