K-Percent Rule

K-Percent Rule.

Under this rule, proposed by Milton Friedman in 1960,31 the Federal Reserve would create money at a fixed rate—say 3 percent per year. By offering the inflation benefits of gold without the potential disruption to the financial system, a K-Percent Rule could be a more politically viable alternative to gold.

The principal flaw is that unlike commodities, a K-Percent Rule is not fixed by physical costs: It could change according to political pressures or random economic fluctuations. Importantly, financial innovation could destabilize the market’s demand for liquidity, as happened with changes in consumer credit patterns in the 1970s. When this happens, a given K-Percent Rule that previously delivered stability could become destabilizing. In addition, monetary policy when

Friedman proposed the K-Percent Rule was very different from monetary policy today. Adopting a K-Percent Rule would require considering what transitions need to take place.

Inflation-Targeting Rules.

Inflation targeting is the current de facto Federal Reserve rule.32 Under inflation targeting, the Federal Reserve chooses a target infla- tion rate—essentially the highest it thinks the public will accept—and then tries to engineer the money supply to achieve that goal. Chairman Jerome Powell and others before him have used 2 percent as their target inflation rate, although some are now floating 3 percent or 4 percent.33 The result can be boom-and-bust cycles of inflation and recession driven by disruptive policy manipulations both because the Federal Reserve is liable to political pressure and because making economic predictions is very difficult if not impossible.

Inflation and Growth–Targeting Rules. Inflation and growth targeting is a popular proposal for reforming the Federal Reserve. Two of the most prominent versions of inflation and growth targeting are a Taylor Rule and Nominal GDP (NGDP) Targeting. Both offer similar costs and benefits.

Economists generally believe that the economy’s long-term real growth trend is determined by non-monetary factors. The Fed’s job is to minimize fluctuations around that trend nominal growth rate. Speculative booms and destructive busts caused by swings in total spending should be avoided. NGDP targeting stabilizes total nominal spending directly. The Taylor Rule does so indirectly, operating through the federal funds rate.

NGDP targeting keeps total nominal spending growth on a steady path. If the demand for money (liquidity) rises, the Fed meets it by increasing the money supply; if the demand for money falls, the Fed responds by reducing the money supply. This minimizes the effects of demand shocks on the economy. For example, if the long-run growth rate of the U.S. economy is 3 percent and the Fed has a 5 per- cent NGDP growth target, it expands the money supply enough to boost nominal income by 5 percent each year, which translates into 3 percent real growth and 2 percent inflation. How much money must be created each year depends on how fast money demand is growing.

The Taylor Rule works similarly. It says the Fed should raise its policy rate when inflation and real output growth are above trend and lower its policy rate when inflation and real output growth are below trend. Whereas NGDP targeting focuses directly on stable demand as an outcome, the Taylor Rule focuses on the Fed’s more reliable policy levers.

The problem with both rules is the knowledge burden they place on central bankers. These rules state that the Fed should neutralize demand shocks but not respond to supply shocks, which means that it should “see through” demand shocks by tolerating higher (or lower) inflation. In theory, this has much to recom- mend it. In practice, it can be very difficult to distinguish between demand-side destabilization and supply-side destabilization in real time. There also are political considerations: Fed officials may not be willing to curb unjustified economic booms and all too willing to suppress necessary economic restructuring following a bust. Either rule likely outperforms a strict inflation target and greatly outperforms the Fed’s current pseudo-inflation target. While NGDP targeting and the Taylor Rule have much to commend them, they might be harder to explain and justify to the public. Inflation targeting has an intelligibility advantage: Voters know what it means to stabilize the dollar’s purchasing power. Capable elected officials must persuade the public that the advantages of NGDP targeting and the Taylor Rule, especially in terms of supporting labor markets, outweigh the disadvantages.

MINIMUM EFFECTIVE REFORMS

Because Washington operates on two-year election cycles, any monetary reform must take account of disruption to financial markets and the economy at large. Free banking and commodity-backed money offer economic benefits by limiting government manipulation, inflation, and recessionary cycles while dramatically reducing federal deficits, but given potential disruption to the financial system, a K-Percent Rule may be a more feasible option. The other rules discussed (infla- tion targeting, NGDP targeting, and the Taylor Rule) are more complicated but also more flexible. While their economic benefits are significant, public opinion expressed through the lawmaking process in the Constitution should ultimately determine the monetary-institutional order in a free society. The minimum of effective reforms includes the following:

Eliminate “full employment” from the Fed’s mandate, requiring it to focus on price stability alone. Have elected officials compel the Fed to specify its target range for inflation and inform the public of a concrete intended growth path. There should be no more “flexible average inflation targeting,” which amounts to ex post justification for bad policy. Focus any regulatory activities on maintaining bank capital adequacy. Elected officials must clamp down on the Fed’s incorporation of environmental, social, and governance factors into its mandate, including by amending its financial stability mandate. Curb the Fed’s excessive last-resort lending practices. These practices are directly responsible for “too big to fail” and the institutionalization of moral hazard in our financial system.

Appoint a commission to explore the mission of the Federal Reserve, alternatives to the Federal Reserve system, and the nation’s financial regulatory apparatus.

Prevent the institution of a central bank digital currency (CBDC). A CBDC would provide unprecedented surveillance and potential control of financial transactions without providing added benefits available through existing technologies.34