The Improvisational Fed, and Unpredictable Regulations

Improvisation can be a wonderful thing when performed by talented hands—Charlie Parker, Miles Davis, and the like. The Federal Reserve, especially for the past several weeks, has fancied itself an improvisational talent on that level. But like most humans, Janet Yellen is no Charlie Parker. They should consider a return to the Paul Volcker/early Alan Greenspan adherence to a defined rule. But that isn’t the end of the story—any substantive Fed reforms will fail unless they are coupled with a thorough program of regulatory reform reaching through the entire executive branch. This post will examine a few worthwhile Federal Reserve reforms, then some regulatory reforms, most of which have already passed the House.

The rest of the executive branch has a similar lesson to learn—more complexity and an ever-increasing stock of rules means less predictability and more uncertainty for businesses, investors, and consumers. Agencies’ increasing tendency to regulating through non-transparent “dark matter” means only makes the problem worse.

As far as the Fed goes, the point is not so much which rule a central bank should adopt, but that it must have a rule in the first place, and follow it consistently. Here are three possibilities.

One is a Taylor rule, which the U.S. Federal Reserve followed for the better part of the 1980s and 1990s, with good results. A Taylor rule raises interest rates when growth and inflation are high, and lowers interest rates when growth and inflation are low. In other words, if the economy looks like it might be overheating, the Fed automatically touches the brakes a little bit. And if it looks sluggish, the Fed pushes the gas pedal a little bit, by predictable, predefined amounts.

The Taylor rule can even be summarized in a single equation, making it easy for central bankers to know how they should react to a given set of economic conditions. The Taylor rule worked pretty well when the Fed was following it, but its attempts at managing the business cycle rub this analyst the wrong way—hubris at worst, spitting into the wind at best.

Another possibility that doesn’t have those problems is NGDP targeting, most famously advocated for by Scott Sumner. Instead of interest rates, NGDP targeting directly targets the money supply itself. If Nominal Gross Domestic Product (NGDP) goes up by 5 percent, then so does the money supply, in lockstep. It attempts to keep each dollar describing the same amount of wealth, which should result in stable, predictable prices. Some central bankers prefer having, say, a 2 percent inflation rate in perpetuity. Why someone would prefer such a thing is beyond me, but the NGDP targeting equation can easily be modified to build in a small inflation or deflation as bankers wish. The important thing, again, is not so much what the inflation level is, but that it is steady, and the Fed sticks to principle, even during a crisis.

There are also significant measurement problems with finding out exactly what GDP is at any given time, but an NGDP targeting rule is still far preferable to the Fed’s whim on any given day.

A third possibility is the Friedman rule, named for Milton Friedman. A Friedman rule deflates the currency at the same rate as the prevailing interest rate on government bonds. The goal is to make people indifferent about keeping money in their wallet, versus a savings account. This means people will make those allocation decisions based on economic efficiency, not the vagaries of inflation. Deflation is unsustainable in the long run, and central bankers are hyper-wary of deflation in general, ironically because of Friedman’s own work. He, along with Anna J. Schwartz, convincingly argued that rapid deflation was the Great Depression’s single largest cause.

Each of these rules—and there are others—has its own advantages and drawbacks. The larger point is that the Fed needs to follow some kind of rule, and stick to it. Its inept free-jazz improvisational approach makes entrepreneurs and investors skittish, and results in far less long-term investment.

Regulatory agencies have similar problems. Would you invest in a 30-year project if you had no idea if the EPA would confiscate your land, or if some other agency finds some obscure rule to kill your project? That’s why regulations to be simple and predictable.

Fortunately, a number of reforms are now winding their way through Congress. The REINS Act, as regular readers know, would require Congress to vote on all executive branch regulations with annual costs of more than $100 million.

The SCRUB Act could save nearly $300 billion per year if it works as planned. It would set up an independent commission to comb through all federal regulations, and send Congress a repeal package for an up-or-down vote, with the goal of trimming at least 15 percent from annual compliance costs, currently estimated at $1.9 trillion.

The ALERT Act would establish a one-in, one-out rule similar to what Canada has had for several years. If an agency wants to issue a new rule, it must first get rid of a similar dollar amount of old rules.

The Sunshine Act would rein in a practice called sue-and-settle, under which activist groups sue agencies for missing deadlines or not enforcing rules strictly enough. Since the agencies are often on the same side, and may in some cases be collaborating behind the scenes, they are only too happy to reach a settlement expanding the agency’s power and authority.

Other options include a regulatory budget, similar to the spending budget the federal government is supposed to issue each year. Each agency would have a “budget” of regulatory costs it is allowed to impose, and must prioritize its rule enforcement so it doesn’t exceed its cap. Finally, automatic sunsets for new regulations would automatically scrub old rules from the books unless Congress sees fit to renew them. This would prevent obsolete or harmful rules from becoming immortal.

The Fed’s improvisational approach does no favors to entrepreneurs, investors, or consumers. Nor does the increasingly arbitrary and capricious approach many regulatory agencies are turning towards. Just as the Fed should bind itself to a predictable and stable rule, so should agencies embrace reform to keep their regulations as simple and predictable as possible.


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