“The desire to follow a rule (and so to avoid the trap of discretionary optimization) does not mean that the bank must refrain from asking itself whether adherence to the rule is consistent with its stabilization objectives. It simply means that whenever this question is taken up, the bank should consider what an optimal rule of conduct would be, rather than asking what an optimal action is on the individual occasion.”Michael Woodford, Interest and Prices: Foundations for a Theory of Monetary Policy
Words mean things. The meaning of a word is rule-like in that the word indicates some object or process. If I refer to a book, it is likely that I refer to a document of probably at least 50,000 words. Yet the meaning of words are not fixed. Over the last decade, it is increasingly likely that I may be referring to an electronic document. The meaning of a word is contingent upon context. It is a function of agreement of those who interpret and use the word.
The meaning of rules constraining behavior operate in a manner similar to the meaning attributed to words. For example, when you are driving on a highway, you might interpret a speed limit sign of 65 MPH as indicating that it is safe to travel between 65 and 70 MPH. Most drivers on the highway, including many officers, seem to agree with this interpretation.
Interpretation of a specific rule is a function of context. Perhaps in more lenient times and regions, the maximum speed indicated by this sign is greater than 70 MPH. In the world of Mad Max, official speed limits likely become meaningless altogether. There, one’s personal speed limit is more likely governed by the regularity and size of potholes in the road.
Marginal reinterpretation of words and of behavioral rules might seem mundane. Yet, this sort of reinterpretation plays a fundamental role in human decision-making. This phenomenon becomes even more significant when they are to guide the behavior of Big Players who steer policy and expectations of policy. Rules intended to constrain policymakers, for example, ought to constrain actions so as to prevent policymakers from generating policies that destabilize the systems they are intended to govern.
Should monetary rules be more or less flexible than the rules of the road? Your answer to this depends upon your belief concerning the purpose of monetary policy and the best way of fulfilling this purpose. Monetary economist Bennett McCallum describes the significance of a monetary rule, noting that it does not allow a policymaker to attempt to steer policy from period to period but, rather, “the authority’s optimization efforts are exerted in the design of the formula to be utilized.” McCallum’s interpretation is consistent with Milton Friedman’s view that the role of monetary policy is to promote stable expectations among investors.
Another popular formulation of the nature of monetary rules is asserted by Michael Woodford. He argues that rule-based policy ought only indicate an overarching goal and clarification of the framework that policymakers use to support the policy goal. Woodford argues that “their commitment must be based upon an understanding of the rational justification of the rule.” If that justification seems to have broken down, then the rule may change.
Sometimes the monetary rule implemented does not generate outcomes consistent with the aims of monetary policy. For example, Paul Volcker briefly targeted the quantity of money when attempting to tackle high rates of inflation. Targeting the quantity of money was accompanied by increased volatility in the velocity of money. So Volcker adjusted his approach, targeting the rate of interest in light of changes in inflation expectations. The strategy, which persisted through the Greenspan era, was successful in stabilizing long-run inflation expectations.
As is often the case, one small detail can radically transform outcomes within a given system. Woodford argues that “the [central] bank should consider what an optimal rule of conduct is . . . [and] reconsider this question as often as it likes [emphasis mine].” While Woodford’s description appears to generally conform to a rules-based approach, his emphasis steers monetary policy more in the direction of discretion, even if this means discretion over rules. For Woodford, then, a rules-based policy boils down to 1) a clearly defined objective and 2) selection of a rule that conforms to this objective with little constraint concerning which rule is selected, how often the rule changes, and how the rule is implemented. Under this approach, the bounds of policymaker discretion over the transformation of a policy framework are difficult to identify and, therefore, to assert in practice.
Problems with Encouraging Active Discretion Over Rule-based Policy
Once a rule is chosen, there is no guarantee that 1) it is a good rule or 2) the rule is being efficiently implemented. From this point of view, Woodford’s assertion seems reasonable. Adoption of a poor rule or policy framework shouldn’t persist due to inertia.
A policymaker should identify and implement a rule and framework that is expected to generate an efficient response to changes in macroeconomic conditions. Ideally, policymakers will eventually identify a rule that can govern monetary policy for long periods, if not in perpetuity. But, perhaps due to concern about uncertainty, Woodford does not emphasize such striving.
Woodford prioritizes a second factor: minimization of an output gap whose magnitude increases with expectation of positive inflation. In the case of the output gap, there is overlap between the thought of Ben Bernanke and Woodford. Bernanke voiced concern over investment that might result as investors hedge due to expectations of short-run volatility of inflation. To avert this short-run instability, Bernanke greatly expanded the means of implementing monetary policy.
Concern over the output gap justified a radical transformation of the framework governing monetary policy that has corresponded with its increasing complexity. The level of intervention by the central bank increased on multiple margins, including an increase in the variety of direct lending provided and financial instruments purchased by the Fed, unprecedented growth in the Fed’s balance sheet, exercise of control over the portion of the monetary base allowed to circulate as well as increasing control exercised by the Fed over the level and structure of interest rates.
Whether the potential for destabilization of investor expectations due to the increase in complexity represents an improved state of the world compared to a situation where monetary policy is defined by a simple interest rate rule with short-term liquidity provision during crises, much like the strategy that defined the Volcker-Greenspan era, is unclear. The most obvious result of the new regime has been increasing cooperation between the Federal Reserve and the US Treasury, which has seen the ratio of federal debt to GDP rise markedly.
Woodford has generally approved of this transformation. In line with Woodford’s formulation, policymakers treat the existence of a framework and a clear objective as approximating a rule, eschewing any rule that would act as a tight constraint on policy decisions. Elsewhere, Woodford supports the use of quantitative easing as a means of limiting financial risk from monetary expansion. He argues that quantitative easing limits the interest rate spread between safe and risky assets, thus discouraging risky investments. Woodford seems to shrug off the possibility that the new regime increases the likelihood of government insolvency. In a footnote he asserts that if the government holds the power to create fiat currency, “then it is possible for it to issue debt that is correctly viewed as completely safe (in nominal terms).” He passes over this problem without considering the effect of debt monetization during a crisis on inflation expectations and, therefore, without considering the effect of this monetization on the value of sovereign debt that banks hold in place of reserves.
I can only imagine that those in charge of monetary policy, following Woodford and the precedent set by Bernanke, see stable implementation of a fixed monetary rule as being an antiquated idea, obviously inferior to their more flexible interpretation of rule-based policy. Their perspective, now widely shared among monetary theorists and policymakers, risks leaving us sleepwalking toward a state of fiscal insolvency.
When pushed to extreme levels, debt monetization and fiscal largesse can, in fact, impact the solvency of banks holding supposedly safe government debt. Even if the quantity of money in circulation is relatively stable, and would not not seem to justify an increase in inflation, the expectation of future monetary expansion intended to offset fiscal insolvency – the kind referred to by Woodford – can generate higher rates of inflation in the present. This unpleasant monetarist arithmetic is more relevant than ever and, yet, remains excluded from the bibliographies of both works by Woodford that I have referenced here.