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Kocherlakota takes on the hottest controversy in monetary policy

REUTERS/Brian Snyder
President Kocherlakota thus continues to play an important role both in formulating current U.S. monetary policy and in setting the research agenda for macroeconomists.

Narayana Kocherlakota, president of the Federal Reserve Bank of Minneapolis, does not intend to leave his position quietly. He made that clear on Saturday at American Economic Association meetings in Boston when he took on one of the biggest issues in macroeconomic policy: the degree to which central banks should have discretion in monetary policy.

To understand what a big deal this is, you need to understand that for many years economists promoted the superiority of economic policymaking based on clearly stated rules instead of allowing policymakers discretion in matters such as setting interest rates. This point of view originated with economists associated with the Minneapolis Fed starting in the 1970s. In his talk, Kocherlakota directly challenged this line of thinking.

Monetary policy rules

The consensus among economists that evolved over the past twenty-five years is that monetary policy (i.e. setting the level of short-term interest rates and thus affecting the entire range of interest rates in the economy) should follow clear, predictable rules. These rules should only be violated in extraordinary circumstances. Of course, there were disagreements about what constituted extraordinary circumstances — a financial crisis like that of September 2008 clearly fit the bill, but other cases, such as the possibility of deflation in the early 2000s, were murkier.

The best current example of a monetary policy rule is the Taylor Rule, named for John B. Taylor of Stanford University. To follow the Taylor Rule, a central bank chooses a target rate of inflation (usually around 2 percent) and estimates the economy’s level of potential output, then sets its short-term interest rate at a level that keeps actual inflation as close as possible to the inflation target and the economy’s real GDP as close to potential output as possible.

In practice, this rule tells a central bank to increase interest rates when inflation rises and/or when GDP is above potential and to cut interest rates when inflation falls and/or when GDP falls below potential.

The Federal Reserve does not explicitly follow the Taylor Rule but by and large macroeconomists find that it explains the Fed’s behavior quite well since the mid-1980s. One exception is when the Fed kept interest rates below the level predicted by the original Taylor Rule in the early 2000s and Taylor himself has argued that this contributed to the housing bubble of 1999 to 2006.

Rules, discretion, and the Great Moderation

There are two reasons for the widespread acceptance of monetary policy rules as superior to allowing central banks wide discretion in setting interest rates. One is theoretical, the other historical.

The theoretical case was first made in 1977 by two economists who for many years have been affiliated with the Minneapolis Fed, Finn Kydland and Edward Prescott. Their paper, “Rules Rather than Discretion: The Inconsistency of Optimal Plans,” set the terms of the debate for the next thirty years and led to their 2004 Nobel Prize. The paper is full of dense mathematics but the authors make their point clearly near the end of the paper: “The reason that [central banks] should not have discretion is not that they are stupid or evil but, rather, that discretion implies selecting the decision which is best, given the current situation. Such behavior either results in consistent but suboptimal planning or in economic instability.”

Economic instability was all around in the late 1970s, with both inflation and unemployment at high and rising rates. The time was ripe for a natural experiment and history now provided one. Starting in the mid-1980s, inflation rates fell throughout the industrialized world and stayed below their 1970s levels for the next twenty years. Unemployment fell as well, more so in the US than in Europe. This period thus came to be known among economists as the Great Moderation.

So, what caused the Great Moderation? One hypothesis, proposed by 2011 Nobel Laureate (and former University of Minnesota and Minneapolis Fed advisor) Thomas Sargent was that the movement by governments away from the kinds of discretionary policies they followed from the mid-1960s until the early 1980s and towards rules-based policies such as the Taylor Rule promoted economic stability and the Great Moderation. Discretion led to economic instability (see the 1960s and 1970s) while rules-based policy promoted stability (see the 1980s, 1990s, and early 2000s.)

Thus, the evidence seemed to support out Kydland and Prescott’s theory. Or did it?

Throughout the Great Moderation there were economists who pointed to an equally likely possibility: that we were lucky and that since the mid-1980s the industrialized world had not experienced any violent economic shocks such as the rapid increases in oil prices seen in the 1970s or the financial crises of the 1930s. They pointed to the period 1880 to 1914, when a period of relative stability was often attributed to the benefits of following the rules of the gold standard but was actually the result of a convergence of a variety of favorable economic factors unrelated to monetary policy. They warned that policymakers and economists were mistaking luck for virtue.

Enter Kocherlakota

The financial crises of 2007-2008 and the Great Recession convinced many economists that good luck was far more important to the Great Moderation than were the adoption of monetary rules. This hasn’t shaken the theoretical case for rules instead of discretion, however, and this is where President Kocherlakota’s recent talk enters the picture. Rather than simply appealing to recent history, Kocherlakota took on the rules versus discretion topic from a theoretical perspective in light of that history.

Kocherlakota presented a theoretical model and applied it to five hypothetical cases in order to make his point. His main point is that recent history clearly demonstrates that the Federal Reserve is biased against letting inflation get out of control. When we build this into our models, and knowing from his experience as a Fed President that policymakers rely “in a complex way, on many indicators of inflationary pressures,” the model suggests that “in the US, discretion is better than any rule.”

For a concrete example of this, think back to the economic expansion of the mid-1990s. The standard economic measures were saying that actual output was close to potential output, creating the danger of inflation. Strict adherence to the Taylor Rule would have required that Fed policymakers raise interest rates. But Fed Chair Alan Greenspan knew the underlying economic data better than anyone and was convinced that, because of the IT revolution, potential output was actually much high than what was indicated by standard measures, and therefore the risk of inflation was actually quite low. Greenspan was able to convince his colleagues not to raise interest rates, and this move likely kept the economic expansion of the 1990s going longer than it otherwise would have.

With Kocherlakota’s Boston speech, the battle has been joined. The rules versus discretion argument is now alive on both the empirical and fronts.

If you think this is all an esoteric argument among economists, think again. This past summer Congress held hearings on a bill that would require the Fed to follow the Taylor Rule. The assumption seems to be that we would have done better since 2008 had Ben Bernanke and his colleagues been constrained in their actions rather than being allowed to do “whatever it takes,” to quote Bernanke.

President Kocherlakota thus continues to play an important role both in formulating current U.S. monetary policy and in setting the research agenda for macroeconomists. There’s certainly gnashing of teeth in some quarters at Kocherlakota’s willingness to challenge the Minneapolis Fed’s research heritage, but I for one look forward to hearing more from the president during his last months in office.

Comments (3)

  1. Submitted by Neal Rovick on 01/06/2015 - 11:57 am.

    As far as my limited exposure to economics goes, it seems to me that economics is an empirical science–based on curve-fitting and precedence. The unfortunate part of this is that the fundamental terrain of economics is ever-changing ( for example, the decoupling of productivity and wages) and so what was clearly linked in the past may be pretty loosely associated in the future.

    Locking specific intervention into law is a blind, dumb thing to do. There certainly is no “stop/go” switch, there is possibly a “go somewhat faster/somewhat slower”lever that can only be moved in fits and starts, but the continued effectiveness of certain actions is not guaranteed over any period of time.

    Response is also determined by specific causes. Either a giant cook-book of many recipes of economic condition and response needs to be written or the sole pot of the same gruel is prescribed for every cause.

    Throw into the mix large players in the economy who employ many very bright minds to sometimes do economically unproductive (in the long-term) things to provide short-term private gain, distorting policy into national disaster. It is not a stretch to imagine these parties positioned to profit mightily from the inevitable policies set into motion by written law at a specific point in an economic cycle. It’s a game and the agility of most of the players outstrips the minds of of the regulators.

    While the singular domination of Greenspan proved to be ultimately problematic, a dead hand at the switch would prove to be even worse and would eliminate the possibility of responding dynamically to ingeniously wrought economic problems.

    In fact, Greenspan proved to be as predictable as written law, and under the changing circumstances of the evolving, impending crisis, kept the same course–crashing into the wall others had seen long before.

    So a Fed with broadly distributed powers (less for the Chairman alone) would provide better guidance, policy and response.

  2. Submitted by Connie Sullivan on 01/06/2015 - 02:42 pm.

    Thanks for another clear article on a sometimes arcane economics question!

  3. Submitted by Paul Udstrand on 01/07/2015 - 11:38 am.

    Empiricism and Economics

    When it comes to empiricism economics has always been an emperor without clothing. Basically economist are always starting with conclusions and working backwards, and the conclusions they start with can be bizarre.

    For instance, describing the decades of the 80s and 90s as a “stable” economic era. Why is this era any more “stable” than the era between 1950 and 1970? In fact, one can describe this so-called era of stability as one of increasing instability leading up to the Great Recession. If you look at GDP charts you’ll see that US GDP between 1950 and 1970 way outperformed the GDP of this so called Great Moderation… unless you define “moderation” as trend towards recession. And don’t forget that this so-called era of “stability” began with the largest recession since the 1930s.

    The problem with these economic analysis is that they never admit they’re only looking at the economy as it pertains to the affluent, and the financial markets. Sure, you can describe the decades of the 80s and 90s as “stable” and “moderate” if you want, but “stable” and “moderate” for whom?

    The top 5% saw their incomes increase hundreds of percent over this period of time, and wealth disparity began it’s march towards the heights of the Gilded Age beginning with the first Reagan tax cut. But the rest of saw recessions, flat and declining household income, several bubbles starting with the Savings and Loan collapse, followed by tech bubbles. We also saw a march towards persistently high unemployment and underemployment as millions of high paying US jobs were outsourced or simply moved out of the country.

    The 80s and 90s were actually quite harrowing for the majority of Americans who saw they income decline while their debt increased to unsustainable levels. We saw so many bubble emerge and burst that some economist started arguing that bubbles are actually good for the economy. Again, good for “whom”? Answer: Those that sell before the burst.

    So what does any of this have to do with monetary policy? Well, I hate to say but there is actually a common sense observation that can be made here… but isn’t; maybe because all that math is planting so many trees that are obscuring the forest.

    Inflation and deflation aren’t about the actual numbers in the sense that inflation or deflation aren’t “bad” or “good” so long as they stay within certain perimeters. Deflation for instance can actually be good for the economy if it’s making life more affordable for a population that’s seen decreasing or flat incomes. Gas prices for instance are a good example, deflation in energy costs can be a good thing for the over-all economy. Dropping home values can also be good in the sense that they make housing affordable. Such deflation can be “bad” for some investors, but you can’t organize a real economy around investors and financial markets alone. Wide spread deflation is a symptom of a poor population that can’t afford existing prices or inflation. As for inflation, as long as people can afford it, it’s not a problem.

    It’s hard to imagine how high interest rates can ever be good for anyone other than banks and bankers. We used to have usury laws that limited interest rates and savings accounts that actually grew with interest, and during THAT era (50s and 60s) the we saw one of the greatest economic expansions in US history. High interest loans just suck money out of the real economy and deposit it into the financial sector where eventually it’s lost in the latest collapse.

    What drives inflation? Is it interest rates? I don’t really know. What I do know is that interest rates alone can’ be the deciding factor. If median wages and salaries are flat, prices can’t go up because no one will have the money to buy stuff. My guess is that part of what’s holding inflation down is the simple fact that 80% of our population has been losing buying power for the last couple of decades. Look at the housing market for instance. For some reason people keep thinking that the housing prices will “rebound” but the fact is people will only pay what they can afford for housing, and people can’t afford higher prices. As long as household income is going down, you’re going to see deflation in the housing market.

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