Policy rules

Monetary economists like rules. Traditionally, they worry that policymakers will sacrifice the long-term benefits of price stability for the more immediate gratification of higher growth. Realizing how hard it is to resist temptation, politicians have delegated monetary policy to a central bank that is independent, but subject to a mandate that constrains their discretion. This institutional setup helped lower inflation in the advanced economies from a median exceeding 10 percent in the late 1970s and early 1980s to about 2 percent by the late 1990s.

But, convinced that overly accommodative financial conditions in the first few years of the century spurred the credit accumulation that fed the 2007-09 financial crisis, there is a push to constrain central banks further by requiring that they publish and account for their actions with reference to a simple policy rule...

Living with uncertainty: What central banks do when they don't know the natural rate

“Unfortunately, we have as yet devised no method to estimate accurately and readily the natural rate of either interest or unemployment. And the ‘natural’ rate itself will change from time to time.” Milton Friedman, American Economic Association Presidential Address, 1968.

What do you do if, on a dark and foggy night, you are forced to drive on a road with a sheer cliff on one side? Unless you know precisely where the road ends and the cliff begins, you will likely go slowly and keep your foot near the brakes. Driving like a tortoise is not the “first best” solution – fog lights that distinguish the road from the cliff would be better. But, absent proper illumination, going slowly is a safe response to perilous driving conditions. It helps prevent catastrophic, irreversible errors.

Such robust strategies are key to central bankers' success as well...

Commentary

Money, Banking, and Financial Markets