Policy rules versus discretion - Lessons from recent history

Critics of central banks have long recommended various operational rules for setting monetary policy instead of allowing the governing boards free reign in making those decisions. Milton Freidman, for example, after an exhaustive study of the Fed’s policy actions during the Great Depression, came to the conclusion that policymakers should adopt a simple rule of steady growth in the monetary base and let interest rates go where they might.1 More recently, central banks have targeted some combination of price stability and full employment, however defined. Those two goals were set out in the Full Employment and Balanced Growth Act of 1978 (informally known as the Humphrey-Hawkins Act) and have become the underlying rationale for most, but not all, Fed policy decisions ever since. Indeed, the Fed only deviated from its dual mandate during four periods over the past forty years - during the early 1990s, briefly in 1998-99, in the early 2000s and after the onset of the Global Financial Crisis in 2008. These episodes provide a glimpse into how the Fed assesses potential risks associated with financial instability, ranging from banking crises and dysfunctional financial markets that disrupt financing to contagion from some other non-financial disturbance. Whatever the source of financial instability, the Fed on those occasions felt free to use discretion in setting policy, for better or worse.

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