Improving the use of discretion in monetary policy

• Date: 01 December 2018
• Author: Frederic S. Mishkin
• Published date: 01 December 2018
• DOI: http://doi.org/10.1111/infi.12337

DOI: 10.1111/infi.12337

ORIGINAL ARTICLE

Improving the use of discretion in monetary policy

Frederic S. Mishkin

Graduate School of Business, Columbia

University, National Bureau of Economic

Research, New York, New York

Correspondence

Frederic S. Mishkin, Graduate School of

Business, Columbia University, National

Bureau of Economic Research, New

York, NY 10027.

Email: fsm3@columbia.edu

Abstract

This paper argues that the rules versus discretion debate has

been miscast because a central bank does not have to choose

only between adopting a policy rule versus pure discretion,

both of which have serious shortcomings. Rather, it can

choose a constrained discretionary regime that has rule-like

attributes. To make monetary policy discretion more rule-

like, it can be improved by (1) adopting a nominal anchor

such as an inflation target, a monetary-policy strategy that

has proved to be very successful in recent years, and (2)

communication of a monetary-policy reaction process,

especially through data-based forward guidance, in which

the monetary-policy authorities describe how the future

policy path will change as economic circumstances change.

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INTRODUCTION

The debate on whether a central bank should have a rule to set its policy instruments or alternatively to

conduct monetary policy with discretion has heated up in recent years. The Financial Choice Act of

2017, which was passed in the U.S. House of Representatives, but has not yet passed in the Senate,

requires the Federal Reserve to report on a ‘directive’rule similar to a Taylor (1993) rule for its policy

instruments. Prominent economists, including John Taylor and several Nobel Prize winners, have

made a public statement supporting this legislation, while other economists and Federal Reserve

officials have argued against the adoption of a directive policy rule.

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In this paper, I discuss where I think the rules versus discretion debate is currently and argue that,

in a sense, this debate has been miscast because a central bank does not have to choose only

between adopting a policy rule and pure discretion. Instead, it can choose to adopt a discretionary

regime that has rule-like attributes, a regime that Ben Bernanke and I referred to as ‘constrained

discretion’in Bernanke and Mishkin (1997). However, can discretion be constrained so it avoids the

disadvantages of pure discretion? The answer I provide here is that monetary policy discretion can be

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© 2018 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/infi International Finance. 2018;21:224–238.