The Fed Needs A Rule | Opinion

Inflation isn't going away anytime soon. Consumer prices rose 8.3% in August, higher than most analysts predicted. There are worrying signs price pressures are broadening: Core inflation, which excludes volatile food and energy prices, reached 6.3%. Wages are rising too, but not fast enough to compensate for two years of eroding purchasing power. The data are clear: American families are hurting.

Despite a century of experience, the Fed still gets basic monetary policy wrong. The problems are not necessarily with policy or personnel, which would be relatively easy to fix. The failure is institutional: Fed officials have too much leeway to make policy on the fly. The proper remedy is a strict monetary policy rule, created and enforced by Congress.

The Fed has been a source of economic instability ever since the Great Depression. Its ad hoc decisions make money sometimes too loose—causing dangerous bubbles and severe price hikes—and sometimes too tight, causing crippling losses of income and employment. For a relatively brief period from the mid-1980s through the early-2000s, it seemed central bankers had cracked the code. Then came the global financial crisis, precipitated by a Fed-fueled bubble from 2003 to 2005.

Analysis by John Taylor, one of the world's most respected monetary policy scholars, shows very clearly what Fed policy should have been. At one point, short-term interest rates were more than 3.5 percentage points lower than economic fundamentals dictated. The Fed was off by a mile. After the bubble burst, Fed dithering protracted the pain. The Fed's own economists estimate the total wealth destroyed by the meltdown was staggering: $70,000 for every American.

Our current woes are also Fed-induced. The central bank's aggressive monetary policies caused the money supply to explode from $15.5 trillion in March 2020 to $21 trillion in 2021. That's a more than 35% increase, far exceeding the market's COVID-induced liquidity needs. Inflation reached its highest levels since the early 1980s as a result.

Federal reserve building
A jogger runs past the US Federal Reserve in Washington, DC on August 18, 2022. - US central bankers remain committed to raising interest rates further to quell rising prices, but agreed it would be appropriate to slow the pace of the hikes "at some point," the Federal Reserve said August 17. MANDEL NGAN / AFP/Getty Images

At the same time, the Fed's interest rate policies have become even more arbitrary. Ever since the Fed started to target short-term interest rates by administrative fiat, the risk of policy-induced malinvestments has skyrocketed. Today, many analysts fear something like the 2008 crisis—this time called the Everything Bubble—is manifesting once again. Money mischief recurs with distressing regularity.

Fixing the Fed should attract support from across the political spectrum. Conservatives and progressives both deplore the effects of inflation on workers' wages and pensioners' fixed-value incomes. Everyone has a stake in smoothing the business cycle, keeping the economy away from the twin perils of unsustainable booms and destructive busts. Sound money transcends partisanship.

Sadly, a powerful alliance between Fed policymakers and Wall Street insiders stands in the way of meaningful reform. Technocrats like to tinker, and financiers like easy money. While the existing regime works fine for those at the top, it's draining the middle class. "Too Big To Fail" is now the law of the land, and taxpayers are stuck holding the bag. We have a chance to short-circuit this failed process by binding the Fed's hands. Monetary policy should support the public interest, not special interests.

Since the Fed is unwilling or unable to police itself, it's time for Congress to step in. Legislators of both parties must work together to force the central bank to follow a specific, verifiable rule. There are several promising options. An interest rate-focused Taylor rule, for one, would give markets guidance about liquidity and credit conditions. An outcome-focused rule, such as a yearly inflation target or a nominal GDP target, would stabilize total demand and hence prevent the economy from getting stuck in a high-unemployment equilibrium.

Each rule has its costs and benefits. What matters most is that legislators pick one and stick with it. Predictability and credibility are the keys to effective monetary policy. Right now, the Fed lacks both.

A reasonable rule, intelligible to the public and defensible on economic grounds, is our best hope to break the cycle. Among devotees of discretion, there will be wailing and gnashing of teeth. So be it. Central bankers must not be a law unto themselves. When it comes to monetary policy, we do not need rulers—we need a rule.

David Brat is Dean of the Liberty University School of Business and a former Member of Congress. Alexander William Salter is the Georgie G. Snyder Associate Professor of Economics in the Rawls College of Business at Texas Tech University, a research fellow at TTU's Free Market Institute, and a senior fellow with AIER's Sound Money Project.

The views expressed in this article are the writers' own.