Give Central Banks Independence and New Political Pressures to Balance the Old Ones

There is a debate about whether central banks should follow a formal rule for monetary policy. (See my view on rules versus discretion in monetary policy in “Next Generation Monetary Policy.”) But there is broad agreement that central banks should follow some kind of systematic monetary policy. As long as carrying out a systematic monetary policy requires any kind of judgment, and as long as politicians have short-run interests contrary to good monetary policy, central banks need tactical independence. But over a longer horizon central banks don’t need fewer political pressures, they need new political pressures to balance out the old ones.

I see political pressures on central banks through the lens of negative interest rate policy. I know from my travels to talk about negative interest rate policy at central banks around the world that central bankers worry about the political blowback from changing paper currency policy as I address in the links in “How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide.” And I worry that many central bankers fail to code it correctly in their brains as implicit criticism of not using vigorous negative interest rate policy when they get criticized for a recovery that is agonizingly slow. In the scary new monetary landscape, there is no refuge from criticism. But central bankers can, if they choose, get criticized inappropriately for doing the right thing instead of getting criticized appropriately for doing the wrong thing.

There is a longstanding set of arguments that have been developed by monetary “hawks,” who in almost all situations argue that interest rates should be higher. There has been little innovation in this area in the last few years, so the set of arguments by John Taylor that I discuss in “Contra John Taylor” can serve as a handy guide to many of them. (Because of his rule, John Taylor does occasionally think that interest rates should be lower, on this occasion, he retails the standard hawkish arguments.) In addition to these standard hawkish arguments that negative interest rates themselves arouse, the idea of changing paper currency policy arouse another set of anxieties about overweening government power. By keeping paper currency in the picture in my proposals (laid out in most detail in work with Ruchir Agarwal 1, 2), I have avoided the vitriol that comes to any threat to the existence of paper currency, but people also get anxious about changing the rules for paper currency.

What is most needed right now is for those who are tempted to lobby for lower interest rates in general to shift gears to lobbying for the elimination of any lower bound on interest rates. In general, I think the Fed makes reasonable decisions in particular circumstances given their overall policy, but there are many dimensions in which their overall policy can be improved, beginning with eliminating any lower bound on rates. Here is the list or proposed upgrading of systematic monetary policy that I argue for in “Next Generation Monetary Policy”:

  1. eliminating the zero lower bound or any effective lower bound on interest rates

  2. tripling the coefficients in the Taylor rule

  3. reducing the penalty for changing directions

  4. reducing the presumption against moving more than 25 basis points at any given meeting

  5. a more equal balance between worrying about the output gap and worrying about fluctuations in inflation

  6. focusing on a price index that gives a greater weight to durables

  7. adjusting for risk premia

  8. pushing for strict enough leverage limits for financial firms that interest rate policy is freed up to focus on issues other than financial stability.

  9. having a nominal anchor.

The Fed knows that it will get political criticism for negative interest rates and changes in paper currency policy. It would help even the odds for good macroeconomic outcomes if the Fed knew it would get criticism for not implementing negative rates, including changes in paper currency policy. Unfortunately, the chances that deep negative rates will be unnecessary in the future are very slim. So it matters greatly for the economy in the future whether the Fed feels political pressure in only one direction or an equipoise of political forces.

Related reading: Don’t miss the links to negative interest rate papers and blog posts in “How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide.”