One of the largest arguments in the economic policy debates is the Discretionary vs Rules based policy. Proponents of rule based policy argue that a rule can tie the Monetary Authorities hands and allow the public to trust the Fed and as such prevent a crisis such as the great recession from happening. On the other side those who prefer discretion based policy believe that policy is to complex to tie down into a single rule and that having the ability to shock the economy can be a powerful tool. While there is theoretical evidence for a rule, discretion based policy or at least a mixed bag strategy may be advisable due to flexibility in a variety of situation and the ability to accomplish what a rule can due if the Fed remains credible most of the time.
The most popular of all rules has been the “Taylor Rule”. This rule (or at least a “baby” version of this rule named the “Baby Taylor Rule”) considers deviations from potential GDP and deviations from target GDP that the economy is currently at. With those deviations parameters or multipliers are added (usually something like .5) and a solution or interest rate is accounted. The “Taylor Rule” when estimating what interest rates should have been over time
(The above figure shows the estimation of interest rates back to 1993 using the Taylor Rule, while also depicting actual interest rates. As shown the rates have been similar except for in recent years.)
has been very historically accurate. We can also see that the largest deviations from what the Taylor Rule has said that interest rates should have been has come since the great recession. It was assumed by many that there was a Zero Lower Bound and that interest rates could not go lower than zero, a belief that until recent times has been assumed to be true. We can also see that this rule based policy would raise interest rates in recent years, which the Fed has not done.
While a rule such as the Taylor Rule has been shown to largely match up with Fed policy this can be strong evidence for discretionary policy. If Discretionary Policy has accomplished what a rule has sought ought to due, then why change current policy. Allowing the Fed the ability in times of need to be able to shock the economy can allow short term output and growth to occur. Per theory put forth by the famous Dr Robert Lucas, because we live in a world of asymmetric information we can effectively shock output as long as the shocks are not systematic and they are not known to be coming to the people. These random shocks or “fooling” the people will lead to real output effects in the short term. Because these shocks most be rare and cannot be used on a regular basis a mixed policy may be best suited for the Fed. Adopting a rule such as a “Taylor Rule” and using it normally as Fed policy would allow credibility to be established of the Monetary Authority. However, allowing the Fed to change policy when needed in times would still leave the government with the ability to stimulate growth in the short term. While it could be argued that adopting a rule that will not be used all the time is not really a rule is true, it still would allow citizens a strong sense of what policy is going to be and leave room for the non systematic shocks. Former Fed Chair Ben Bernanke supports this Discretionary Policy type (with a Taylor Rule type guideline). “Originally, John did not seem to believe that his eponymous rule should be more than a general guideline. Indeed, in his 1993 article, he took pains to point out that a simple mechanical rule could not take into account the many factors that policymakers must consider in practice” (Bernanke, 2015). This reminds us that while a rule can be useful for establishing credibility and that a established rule (even any type of rule) could theoretically prevent a recession from even happening due to foresight, that a rule is still manmade and imperfect. An imperfect and rigid rule that we must adhere to in all situations may not be optimal for when a recession hits. This is unfortunately due to life being full of exogenous shocks that we cannot control. Leaving fluidity and control in the Fed’s hands may be the best solution if we can trust the monetary authorities to not abuse these shocks and leave them for times of need.