The economy remains one of the hottest topics in the news, and there has been intense focus on the Federal Reserve’s decisions to raise interest rates to cool inflation.
In this Q&A, Pierre Yared, the MUTB Professor of International Business at Columbia Business School, shares relevant insights from his latest research on the topic, which looks at the rising popularity of guiding monetary policy through target-based rules.
Q: Your research has examined central bank policies concerning instrument-based versus target-based rules. Can you elaborate on the distinction between those two approaches?
Pierre Yared: There’s an ongoing debate among central banks as to whether they should focus on the exact policy that they choose or focus on the goal or target of that policy. Let me give you an example in the case of the US and an example for the case of emerging markets.
Since the early 2010s, the US Fed has focused on achieving an inflation target. This is an approach pursued by numerous other central banks across the world. This is a target-based rule, since the focus is on the goal of policy, which is inflation stabilization, without specifying the exact policy to get there. Another possibility for the US Fed would be to follow something like a Taylor rule—an exact formula mapping current levels of inflation and economic activity directly to an interest rate the Fed should set. This is an instrument-based rule, since the focus is on the policy rate and not on the ultimate goal of that policy.
It turns out that a Taylor rule was a pretty good description of US interest rate policy up until the global financial crisis, when interest rates declined all the way to zero. At that point, the Taylor rule forecasted negative interest rates, which were never chosen by the Fed, and the Fed stopped following the rule during the crisis and during the recovery. In the present environment, there are some renewed proposals for the US to return to a mechanical Taylor rule. By the way, if the Fed were to follow a Taylor rule today, interest rates would be much higher than they are right now, since inflation is extraordinarily high. We do not see that, since the Fed is continuing to follow an inflation-targeting framework.
In emerging markets, the distinction between instrument-based and target-based rules takes a slightly different form. Some emerging market central banks do follow an inflation target like the Fed, but several of them follow an instrument-based rule in the form of a fixed or managed exchange rate. In other words, their focus is on the instrument of policy—the exchange rate—without concerning themselves explicitly with the goal or target of policy.
Q: Which approach do you see leading to better potential outcomes in today’s economy?
Yared: The punch line in the research is that if the central bank has a lot of credibility and is extremely independent from political pressure, then it’s better off following an inflation target relative to an instrument target. The reason is because an inflation target provides a lot of flexibility. The central bank is better able to tailor the instrument of policy to the economic conditions. And it’s not going to be off the mark too often.
In contrast, if the central bank is subject to a lot of political interference, it’s better off having an instrument-based rule like a fixed exchange rate. The central bank loses a little bit of discretion in terms of its ability to respond to shocks, but it also gains a lot in terms of credibility vis-a-vis inflation and predictability. The private sector is able to forecast exactly what the central bank is going to do, so policy volatility is lower. So the central bank ties its hands and buys itself a little bit more credibility at the loss of flexibility. And that turns out to be a pretty good outcome if you have a relatively non-independent central bank to begin with. Perhaps this fact can explain why some emerging markets continue to opt for fixed exchange rate regimes as a way to increase the credibility of their monetary policy.
Q: What does your research suggest for the US?
Yared: In the US, this means that as long as we live in a world where the Fed is relatively insulated from political pressure and is able to focus on inflation, we’re best off giving the Fed a lot of flexibility to follow a target-based criteria versus an instrument-based one. That’s the case if those are the only two options on the table.
If we allow ourselves to think more creatively, though, my research suggests that we’re actually better off with a hybrid arrangement that combines features of instrument-based and target-based rules. An ideal framework for a central bank is to pursue instrument-based rules under normal circumstances but switch to target-based rules during extraordinary times. For the US, this would mean that we would expect the Fed to follow a Taylor rule, but we would also allow the Fed the discretion to switch to a target-based rule if it decides that extraordinary circumstances—like the global financial crisis, for example—require it to deviate from the Taylor rule in the pursuit of more expansionary policy.