Interest-rate rules can strengthen central banks

As Donald Trump has assumed office as President of the United States, a new bill regarding the Federal Reserve Bank might receive a fresh boost. In a paper published via VoxEU, Volker Wieland and Henrike Michaelis of the German Council of Economic Experts argue that the new legislation and a monetary policy based on interest-rate rules are not necessarily a disadvantage, and, on the other hand, may even enhance the independence of the Federal Reserve.

The so-called FORM Act (Fed Oversight Reform and Modernization Act) comprises new accounting rules as well as a rule-oriented monetary policy. If ratified, this new law could change the Fed’s work routine remarkably. On January 19, Fed Chair Janet Yellen already explicitely referred to interest-rate rules – in a similar way as required under the FORM Act.

Michaelis und Wieland demonstrate how argumentation along the lines of interest-rate rules does not limit the Fed’s scope for action but “would serve to bolster the Federal Reserve’s independence“, “if ever a President would try to exert pressure on the Fed to keep interest rates too low for too long in order to boost activity during his or her term and improve chances for re-election“.

As the economist John B. Taylor of Stanford University and the Hoover Institution mentions in a blog entry, the authors also point out where Yellen’s argumentation falls short. “They show that the comparison is incomplete and thereby misleading because it uses only part of recent research”. Michaelis and Wieland show that acting consistently in accordance with the interest-rate rules “moves the implied rate in the opposite direction”.

Henrike Michaelis and Volker Wieland
"R-Star and the Yellen Rules"

John B. Taylor, blog "Economics One"
"Benefits of Comparing Policy with Reference Rules"

FAZ: "Amerikas Geldpolitik vor neuer Epoche"