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Rules and directions

Posted by
January 14, 2015

Ben Bernanke once got lost on his way to a meeting in Washington, D.C. When Bernanke stopped to ask for directions, the exchange went something like this:

Bernanke: I seem to be lost and was wondering if you could point me in the right direction.

Stranger: Sure. Where are you headed?

Bernanke: It doesn’t matter where I’m headed. Just tell me which way to go!

Ok, obviously I made that up, but Michael Belongia notes that the above example is how monetary policy is often conducted. In a great Econtalk podcast with Russ Roberts, Belongia describes how Fed meetings often go when the Board of Governors asks an economist for advice on monetary policy. It goes like this:

Governor: What should the Fed do about monetary policy?

Economist: They should adopt a rule like the Taylor Rule, or an NGDP target, etc.

Governor: We don’t have time for that. We need to decide what the Fed should do today!

On hearing the above exchange, many people would side with Fed governor. Why is the economist stuck in his Ivory Tower of monetary theory? Doesn’t he understand the Fed has a job to do? Can’t he just make a concrete recommendation about what the Fed should do today?

As Belongia points out, however, no one can know what’s best today without knowing where the Fed wants to go in the future. Just as in the anecdote of Bernanke asking directions, we can’t make concrete short-run recommendations without having a long-run goal.

This is why rules are so important for monetary policy. It’s not enough just to give the Fed discretion and tell them to do a good job. The Fed needs a specific long-term goal to guide its short-term decisions.

Nor can the Fed credibly pursue a dual mandate of minimizing both inflation and unemployment. Imagine:

Bernanke: I seem to be lost and was wondering if you could point me in the right direction.

Stranger: Sure. Where are you headed?

Bernanke: I’m simultaneously headed to New York and the White House.

Stranger: ????