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Why no rules are good rules for monetary policy

A Canadian dollar, left, and a Euro are seen next to a series of U.S. dollars. Legendary U.S. economist Milton Friedman was the most well-known of the rules-based crowd, famously calling for the Fed to be replaced by a computer that would simply let the money supply grow at a steady rate.


Philip Cross is a senior fellow at the C.D. Howe Institute and former chief economic analyst at Statistics Canada

John Taylor was on the short list, with Ben Bernanke to succeed Alan Greenspan as chairman of the Federal Reserve Board in 2006. The recent publication of his latest book First Principles is a reminder of the ongoing debate between those who want monetary policy to be rules-based and those who want more room for discretion in its conduct.

Milton Friedman was the most well-known of the rules-based crowd, famously calling for the Fed to be replaced by a computer that would simply let the money supply grow at a steady rate. Taylor advanced what came to be known as the Taylor Rule, which says that monetary policy should respond almost mechanically to changes in inflation and the gap between current and potential output.

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The resurgence of interest in rules-based monetary policy is heard in nostalgic calls, mostly from the right wing of the Republican party, to bring back the gold standard. Presidential candidate Ron Paul epitomizes this group, calling for the Federal Reserve Board to be abolished. This distrust of the Fed has its origins in whether the Fed will be able to rein-in its bloated balance sheet before re-igniting inflation, although the Bank of Canada already has demonstrated that this can be done.

There are several problems with the sentiment to move to more automaticity in monetary policy. It starts with a misunderstanding of the gold standard. For many, the gold standard simply means having the money supply backed by a largely-fixed quantity of gold. However, according to Barry Eichengreen in his book Golden Fetters, the gold standard (if you will pardon the expression) for studying the gold standard, at no time did central banks behave mechanically. Instead, central banks "retained discretion over when and how to intervene, discretion that was integral to the system's operation".

In his new book, Taylor lauds Paul Volcker and the Fed for targeting inflation during the 1981-1982 recession, which set the stage for the robust expansion of the 1980s. What is overlooked, however, is that Mr. Volcker initially set the targets for money supply growth, as Friedman wanted, not inflation. In the spring of 1982, the Fed was faced with the choice of raising interest rates to rein-in an upturn in monetary growth, or lowering rates to fight the ongoing recession. The Fed chose to raise rates, which resulted in unnecessarily prolonging an already severe recession. The Fed learned its lesson, abandoning targets for the money supply altogether as it ditched formal rules for monetary policy.

The Bank of Canada clearly favours the use of discretion and not just rules in setting monetary policy. In a speech earlier this year, Governor Mark Carney openly stated that interest rates in Canada were kept lower than a simple Taylor-type rule policy would have implied as the recovery unfolded, reflecting the fragility of growth in the aftermath of the crisis. Canadians should be reassured that discretion is exercised here, just as Americans should be that Mr. Bernanke and not Mr. Taylor was selected to head the Federal Reserve.

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