Misconceptions Regarding Rules vs. Discretion for Monetary Policy

Shortly after the most recent of the famous annual symposiums at Jackson Hole, sponsored by the Federal Reserve Bank of Kansas City, one of my colleagues asked me if I had seen the New York Times and Wall Street Journal articles on the conference. They seemed newsworthy, he suggested, because of their reports that Alan Greenspan had come out clearly in opposition to the adoption of any monetary policy rule for the Fed. (1) I replied that I would certainly look at the articles, adding that Greenspan had explicitly expressed his opposition to rule-based policymaking on at least one previous occasion, probably more. (2) Upon reading the two articles, I found that both quoted from the following statement of Greenspan's: "Some critics have argued that [the Fed's] approach to policy is too undisciplined--judgmental, seemingly discretionary, and difficult to explain. The Federal Reserve should, some conclude, attempt to be more formal in its operations by tying its actions solely to the prescriptions of a formal policy rule. That any approach along these lines would lead to an improvement in economic performance, however, is highly doubtful" (Greenspan 2003: 4). Comments and panel discussions by Vincent Reinhart, Janet Yellen, Stanley Fischer, and Martin Feldstein mostly lent support to Greenspan's remarks in this regard, although there are a few reservations implicit in some of their passages. At about the same time, I received in the mail a copy of Michael Woodford's new book on monetary theory and policy, Interest and Prices (Woodford 2003). This 785-page treatise is almost certainly the most ambitious treatment of the topic to appear since Don Patinkin's Money, Interest, and Prices (1956), and is an immensely sophisticated work that seems destined to become a classic in economic analysis. The point relevant to the matter at hand is that Woodford's first chapter (of 58 pages!) is entitled "The Return of Monetary Rules" and includes a section called "The Importance of Policy Commitment." Thus, there seems to be a major difference of opinion between academic analysts and central bankers, at least in the case of the Fed, concerning the desirability of monetary policy rules. Since the Shadow Open Market Committee regularly consults the indications from two such rules, the well-known Taylor Rule and another one that is of my design (McCallum 1988), this matter cries out for attention. The first argument that I want to make is that the two groups, central bankers and academics, evidently have different practices in mind when they refer to "monetary policy rules." Thus, there could be less actual disagreement between (e.g.) Greenspan and Woodford than appearances and newspaper articles suggest. In fact, it is arguable that some leading central banks--though not the Fed--are actually conducting policy, at present and over the past several years, in a manner that is more consistent with "rules" than "discretion," in the sense of these terms as used by academics. My second argument, however, will be less cheerful. It is that the Fed seems to deny or misunderstand the importance of the type of rule-based policymaking that academics have in mind. This misunderstanding, furthermore, is currently contributing to the problems of "communication with the public" that the Fed has been experiencing, as recently reported in the Wall Street Journal by Ip (2003b). The actual problem, I will argue, is not primarily one of communication but one of policy substance. Two Conceptions of Rules vs. Discretion When central bankers object to the use of a policy rule, they typically refer to alleged constraints on policy flexibility. Evidently, the conception that they have in mind--at least in many cases--is a regime in which the central bank "has turned policy decisions over to a clerk armed with a simple formula and a hand calculator" or possibly "to a team of PhD economists armed with computers and Matlab programs" (McCallum 2000: 274). …