America has now had nearly a century of decision-making experience under the Federal Reserve Act, first passed in 1913. Thanks to careful empirical research by Milton Friedman, Anna Schwartz and Allan Meltzer, we have plenty of evidence that rules-based monetary policies work and unpredictable discretionary policies don’t. Now is the time to act on that evidence.
The Fed’s mistake of slowing money growth at the onset of the Great Depression is well-known. And from the mid-1960s through the ’70s, the Fed intervened with discretionary go-stop changes in money growth that led to frequent recessions, high unemployment, low economic growth, and high inflation.
In contrast, through much of the 1980s and ’90s and into the past decade the Fed ran a more predictable, rules-based policy with a clear price-stability goal. This eventually led to lower unemployment, lower interest rates, longer expansions, and stronger economic growth.
Unfortunately the Fed has returned to its discretionary, unpredictable ways, and the results are not good. Starting in 2003-05, it held interest rates too low for too long and thereby encouraged excessive risk-taking and the housing boom. It then overshot the needed increase in interest rates, which worsened the bust. Now, with inflation and the economy picking up, the Fed is again veering into “too low for too long” territory. Policy indicators suggest the need for higher interest rates, while the Fed signals a zero rate through 2014.