The problems with “rules-based” monetary policy

Rules based monetary policy has been the talk of the town for a while. The debate is getting shriller as US polity is debating on giving Fed a rules based mon policy mandate.

Though, rules based policy looks like a better model than discretion based, we don’t understand there is discretion in making those rules as well. How does one decide what the rule should be? Usually it is the Taylor rule which is suggested as a way to make these rules. But Taylor rule is based on inflation and potential output, both of whose calculation is discretion based.

Tommy Behnke writes on this problem:

Though the guiding principles of the Taylor Rule may sound rather prudent in theory, they are far from simple in practice. In fact, it is nearly impossible to accurately compute the two pieces of economic data — inflation and potential output — that this formula is dependent upon.

…..The Taylor Rule is no more accurate at determining interest rates than meteorologists are at forecasting the weather. The only difference between the two is that weathermen are precise on occasion, whereas the federal funds rate under the Taylor Rule is, at best, less wrong.

Setting the price of money and credit in the name of unleashing the economy’s supposed potential output is the equivalent of enacting price controls on milk to unlock its full buying power. It’s a fallacy that cannot be achieved. The sooner the Fed pawns off its printing press, the sooner its market distortions will be lifted; and the sooner that each individual will be able to make rational decisions that make sense for not only himself or herself, but for the economy at large as well.

🙂 Strong words..

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