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 Monetary Policy Making: A Case against Discretion
By Mason Hackmann, University of Chicago

Background

The Founding Fathers were more than skeptical of central banking and paper
money. Alexander Hamilton, the first Treasury secretary for the United States,
warned that fiat currency—by its very nature—is subject to abuse.1 Thomas
Jefferson, the author of the Declaration of Independence, went so far as to write
to John Taylor, a political theorist at the time of the American Revolution, that
“banking establishments are more dangerous than standing armies.”2

America’s central bank, the Federal Reserve System, has held interest rates
arbitrarily low for the majority of the current century.3 In light of the COVID-19
pandemic, government-implemented lockdowns gave rise to an economic shutdown,
leading to the furtherance of easy money and intense quantitative easing by the
Fed. By official measures, the rate of inflation in the United States hit a forty-year
high as a result.4 The methodology for calculating the consumer price index has
changed—in order to account for substitution and hedonics—but if the original
methodology is applied, today’s annualized inflation rate exceeds that of many
years during the Great Inflation of the 1970s.5

The Fed controls the money supply primarily by the utilization of price controls on
interest rates—the price of borrowing, to be sure—in accordance with its dual
mandate of balancing employment and price stability. In principle, this is central
planning enacted through the power of the state. As evidenced by history and
economic theory, governments too often create egregiously suboptimal outcomes in
the way of utility and—from some normative perspective—liberty. To that end, the
abuse of printing money has even been cited as a major cause for the decline of
some of the world’s most powerful civilizations for its damage to real productivity
growth and distortions to the natural functioning of the market.6

There are, of course, those who proclaim a new paradigm vis-à-vis the nature and
causes of inflation, but the recent price increases at the very least demonstrate
the improbability of so-called modern monetary theory’s validity. The era of low
interest rates being inconsequential to price stability is over. Furthermore, efforts
have been made to convince the public that high inflation can actually be something
positive on egalitarian grounds even though it diminishes the purchasing power of
the consumer.7 To the contrary, inflation is effectively a regressive tax, as price
increases disproportionately affect the welfare of middle-class consumers while
the expansionary monetary policies that beget a rise in the price level appreciate
asset prices—in short order, a positive for those with significant financial assets who
spend a negligible portion of their income on consumption.

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It follows that tolerating high inflation becomes a slippery slope. While there is
considerable disagreement among economists on the proper form of monetary
policy making, empirical evidence suggests serious limitations to the Fed’s ability
to increase employment in the short run.8 In the long run, that ability is still more
limited, if it even exists at all.9 As such, constraints need to be placed on the central
bank to greatly limit its discretion with respect to policy making, given the reality—
however rasping—of actual market dynamics and the severity of what is at stake.

Recommendations

A few centuries after Thomas Jefferson delivered his aforementioned remarks to

John Taylor, a different John Taylor offers a credible solution to rein in the Fed’s
discretionary monetary policy: a rules-based approach for setting the federal
funds rate’s target range, the interest rates of foremost importance to the economy.
The period from 1985 to 2003 was arguably characterized by rules-based
monetary policy that considered both the rate of real productivity growth and the
rate of change in the price level, while the 1960s and 1970s, along with the period
following 2003, saw central-banking practices that were largely discretionary in
nature. The age of rules-based monetary policy was a time of enhanced economic
performance, and analysis has suggested this relationship was causal.10

It is endlessly proclaimed that supply-chain bottlenecks are largely to blame for the
current inflation. Other inflation scapegoats, discussed ad nauseum in international
media, range from corporate greed in the form of intense price gouging to
Russian president Vladimir Putin’s policies. The main driver of this unprecedented
inflationary pressure, however, is irresponsibly low interest rates that constitute an
expansion of the money supply and a staunch deviation from what is practical.
The Fed failed to raise interest rates at the appropriate time (per the rate that
should be targeted deriving from the Taylor Rule derived by rigorous academic
studies) for fear of inducing a deep recession. Although not entirely misaligned
with political incentives and human nature as it relates to time preference, such fear
is ungrounded: a greater amount of damage in the way of a recession might arise
from inaction to the extent that the Fed holds rates below an appropriate level.11

It should come as no surprise that the national debt is incredibly high by historic
standards and compared to what is permitted, so to speak, in a healthy market
economy. The Fed cannot, however, accommodate reckless fiscal policy: monetizing
the debt is not just improper on theoretical grounds, it violates the legal mandate of
political independence established by Congress. In a world wherein discretionary
monetary policy making is permitted or even encouraged, it is all too easy for a
central bank to become hostage to the short-run performance of the economy as
opposed to remaining a steward of the optimization of long-run productivity and
the resultant living standards.

Naturally, the Fed does not outright claim the intention of a serious deviation from
policy making that achieves its dual mandate of maximizing employment and

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 minimizing inflation. It therefore follows that an adherence to interest rates set
through the formula prescribed by the Taylor Rule helps to uphold the credibility
of the central bank. Indeed, there is a correlation between the aforementioned
period of rules-based monetary policy and the Fed’s credibility.12 When the Fed
has less credibility, it needs to take more intense action to achieve its policy goals
against the backdrop of worsened expectations: in other words, greater rate hikes
and thus a deeper recession are requisite to address heightened inflation.13

Expected Results

If Congress reins in the Fed with an alteration to its dual mandate that requires
interest rates to be set to levels implied by the Taylor Rule or at least levels
significantly closer—with some explicitly stated error band—than has been recent
precedent, greater price stability should arise along with a higher rate of real
GDP growth than the alternative. And, of course, inflation crises the likes of which
we are experiencing should occur less often. The Fed’s credibility should increase
as a result, which would make its job significantly easier and the business cycle’s
road less bumpy.

The world does not behave like simple economic models, which are dependent
on a myriad of highly unrealistic assumptions. We cannot simply conclude that
less economic growth and higher inflation relative to historical growth levels and
inflation rates imply that the policy prescription of rules-based central banking
is unsuccessful if implemented. Nor can we assume that more economic growth
and lower inflation—again, relative to historical growth levels and inflation
rates—indicate the success of implementing the Taylor Rule in an effort to subdue
discretionary power. Rather, econometrics needs to be used against the backdrop
of theoretical contextualization to assess the policy’s legitimacy.

Empirical methods of linear regression that compensate for the fact that all factors
are not held constant are of critical importance. The methodology used by economist
John Taylor to analyze the period of relatively rules-based monetary policy and
that of more ad hoc decision making in the way of setting interest rates is highly
lauded and serves as a prime model for evaluating policy implementation. As
would be expected, a more expansive time series should provide more conclusive
results.

While the future is characterized by radical uncertainty and the great difficulty
of making perfectly accurate economic forecasts, rules-based monetary policy
is a promising policy goal. The most thought-out frameworks that describe the
world, not as it ought to be, but rather as it truly is, lead to the ideas discussed
in this policy proposal. Nobel laureate Milton Friedman famously asserted that a
computer could assume the role of central banker.14

While the implementation of rules-based monetary policy suggested by Taylor is

not entirely aligned with Friedman’s ideally functioning macroeconomy, the essence

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is all but the same: individuals are incapable of centrally planning the direction of
the economy. Arbitrary interest rates, which are intrinsic to discretion-based central
banking, necessarily lead to an arbitrary allocation of resources.

Banking institutions, if left under the sole direction of a central planner, may well
be as dangerous as Jefferson believed them to be more than two hundred years
ago. From the events of the past century, history teaches us that it would be unwise
to allow the Fed to gamble with America’s great civilization in a deviation from the
way of the market.

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 Endnotes

1
Deroy Murdock, “Founders: No Fans of Paper Currency, National Review, May 25, 2021,
https://www.nationalreview.com/2011/07/founders-no-fans-paper-currency-deroy-
murdock.
2
Thomas Jefferson, “Thomas Jefferson in a Letter to John Taylor Condemns the System
of Banking as ‘a Blot’ on the Constitution, as Corrupt, and That Long-Term Government
Debt Was ‘Swindling’ Future Generations (1816),” Online Library of Liberty, https://oll.
libertyfund.org/quote/thomas-jefferson-in-a-letter-to-john-taylor-condemns-the-system-
of-banking-as-a-blot-on-the-constitution-as-corrupt-and-that-long-term-government-debt-
was-swindling-future-generations-1816.
3
John B. Taylor, “Monetary Policy Rules Work and Discretion Doesn’t: A Tale of Two Eras”
(lecture, Ohio State University, September 21, 2011), https://web.stanford.edu/~johntayl/
JMCB%20lecture.pdf.
4
Christopher Rugaber, “US Inflation at New 40-year High as Price Increases Spread,”
AP News, June 10, 2022, https://apnews.com/article/key-inflation-report-highest-level-in-
four-decades-c0248c5b5705cd1523d3dab3771983b4.
5
Stuart A. Thompson and Jeanna Smialek, “Why Has the Inflation Calculation Changed
over Time?” New York Times, May 24, 2022, https://www.nytimes.com/2022/05/24/
technology/inflation-measure-cpi-accuracy.html.
6
Ray Dalio, Principles for Dealing with the Changing World Order (New York: Avid Reader
Press, 2021).
7
Edward N. Wolff, “The Upside of Inflation? It Reduces America’s Enormous Wealth Gap,” Los
Angeles Times, February 22, 2022, https://www.latimes.com/opinion/story/2022-02-22/
inflation-effects-wealth-inequality-black-white.
8
Thomas J. Sargent, “Rational Expectations,” Econlib, https://www.econlib.org/library/Enc/
RationalExpectations.html.
9
James A. Dorn, “The Phillips Curve: A Poor Guide for Monetary Policy,” Cato Journal,
Winter 2020, https://www.cato.org/cato-journal/winter-2020/phillips-curve-poor-guide-
monetary-policy.
10
Taylor, “Monetary Policy Rules.”
11
Melissa De Witte, “What Causes Inflation? SIEPR’s John Taylor Explains,” Stanford News
Service, https://siepr.stanford.edu/news/what-causes-inflation-sieprs-john-taylor-explains.
12
William T. Gavin and Diana A. Cooke, “The Ups and Downs of Inflation and the Role of
Fed Credibility,” Federal Reserve Bank of St. Louis, April 1, 2014, https://www.stlouisfed.
org/publications/regional-economist/april-2014/the-ups-and-downs-of-inflation-and-the-
role-of-fed-credibility.
13
Kevin L. Kliesen, “A Recipe for Monetary Policy Credibility,” Federal Reserve Bank of
St. Louis, October 1, 1996, https://www.stlouisfed.org/publications/regional-economist/
october-1996/a-recipe-for-monetary-policy-credibility.
14
James Pethokoukis, “Maybe It’s Time for a Computer to Run the Fed After All,” AEIdeas,
November 23, 2021, https://www.aei.org/economics/maybe-its-time-for-a-computer-to-
run-the-fed-after-all.

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