ORANGE, Calif. (Reuters) – Requiring the Federal Reserve to operate according to a monetary policy rule could generate worse economic outcomes than using a goal-based mandate like an inflation target, a top Federal Reserve official said on Friday.
“Particularly in situations of economic stress or crisis, operational mandates have proven to be ineffective and have often been abandoned,” San Francisco Fed President John Williams said in remarks prepared for delivery at Chapman University.
That view is widely held among Fed policymakers, who believe that forcing the U.S. central bank to inflexibly follow a fixed monetary policy rule would inhibit its ability to right the economy during a crisis. Such a requirement is the centerpiece of legislation recently proposed in the U.S. Congress as part of an effort to beef up oversight of the central bank.
Fed Chair Janet Yellen last year said the proposal would be a “grave mistake.”
What stood out about Williams’ remarks Friday was his comparatively restrained tone.
A policy-rule-based approach is “unquestionably superior” to past efforts to stipulate the central bank’s approach to policy, including the failed gold standard and the fixed-exchange-rate mandate, he said.
Still, Williams said, before “rushing into” such an approach, legislators should consider circumstances in which it might fail, including times when the economy shrinks so dramatically that negative interest rates would be required. The unconventional monetary policy the Fed followed after the 2007-2009 financial crisis, he noted, would have fallen outside a rules-based approach.
“Mechanically following one type of standard policy rule designed to work well under one set of assumptions can yield very poor economic outcomes when those assumptions are violated,” Williams said.
There are also questions, he said, about how to define certain aspects of a policy rule, including the definition of full employment, which changes through time.
“A potentially more promising approach to address the independence dilemma may be to look to the experiences of inflation-targeting countries, where the principle of enhancing accountability and transparency within a goal mandate framework has proven to be very successful.”
Williams said one approach is to follow the lead of some other major central banks, whose heads must make public explanations when inflation targets are missed.
The Fed’s 2 percent inflation target, which it has missed for many years running, is set internally and is not subject to such formal public accounting.
(Reporting by Ann Saphir; Editing by Leslie Adler)