Now Hiring: The Federal Reserve

Have a passion for monetary policy? Time to polish up your resume, because President Trump will nominate some new Federal Reserve Board members-and possibly a new chair-in the coming months. Rumor has it he favors folks who prefer setting interest rates according to a set formula (or rule), rather than a "discretionary" approach in which Fed members' independent judgment rules. This debate probably strikes you as esoteric and far removed from markets. But given that investors have fixated-wrongly, in my view-on the Fed throughout this bull market, the "rules-vs-discretion" divide could become an undercurrent as appointments emerge, with both sides bemoaning the possibility of a mismanaged Fed. To inoculate you against these worries, here is a discussion of why there is little distinction between rules-based and discretionary monetary policy-and thus, wherever Trump stands on this debate isn't hugely relevant for this bull market.

Ready? Set! Rules! The best known-the Taylor rule-is named for economist John Taylor, whose possible spot on Trump's shortlist has renewed debate over his ideas. In his own words, Taylor argues the rule would "increase interest rates by a certain amount when price inflation rises and decrease interest rates by a certain amount when the economy goes into a recession." Sounds simple. But in calculation, the practitioner is required to know the current neutral rate of interest (more on that shortly), formulate a forecast of GDP growth and potential GDP growth (more on that later, too!) and inflation. Then, you mash them all together and, voila, the Taylor Rule shows you where the fed-funds target rate ought to be. If you don't want to do all that math, you can see the St. Louis Fed's estimate of how this rule compares to rates presently here.

Whatever the formula, the rule's primary goal is to keep monetary policy stable and predictable. In opposition, discretionary fans declare there should be just one rule: No rules! Rigid, narrow formulas, they say, keep the Fed from responding flexibly to changing economic conditions. It sounds like the two sides couldn't be further apart. But the lively debate misses something crucial: Rules or no, central bankers must make lots of judgment calls. That's why a more rule-bound Fed isn't practically all that different from a discretionary one-too much is up for interpretation. Consider everything they would need to sort out:

1. Which rule is best?
Rates could vary several percentage points with each rule. But what if we just pick one formula and stick with it? More fog! Take a basic question:

2. What is inflation?
Sorry, "inflation is when prices are rising" won't cut it-you have to pick a metric. The Fed currently uses PCE, or "Personal Consumption Expenditure," which tracks price changes in the PCE portion of GDP. Another common measure is the Consumer Price Index. But Taylor used something called the GDP deflator, which includes economy-wide prices, not just consumer goods. And there are multiple forms of PCE-headline (covering all goods) and core (all but volatile goods like food and energy). The Fed itself said for years it tracked core PCE, but then (oddly) shifted to headline. So ... which will it be? Or maybe a mix? This-dare I say it?-is a discretionarydecision.

3. What is the natural rate of interest?
The natural rate of interest is imaginary. Loosely, it is the real (inflation-adjusted) fed-funds rate at which real GDP growth matches its potential (notwithstanding the odd shock) without driving inflation higher. The original Taylor rule pinned the rate at 2%, but many Fed members argue it has fallen in recent years, lowering the formula's recommended rate.

4. What is potential output?
Potential GDP-what the economy's output would be if its capital and labor resources were fully employed-is a hot topic in academic circles and a key component of monetary policy rules. However, it's a purely theoretical concept whose accuracy can't be tested or proven. It's impossible to pin down a figure for something that (like anything "potential") doesn't exist, and representing a hazy counterfactual with a concrete data point doesn't change this. There is little agreement today on where (and what) potential GDP is, and Fed members' interpretations of the measure are changing.

5. How strongly should the Fed react when inflation or output misses the target?
The economy is overwhelmingly likely to correct on its own if given enough time, so the Fed must choose how rapidly to shift interest rates in order to speed up the process. But the Fed could craft a rule that calls for greater or less responsiveness to wibbles and wobbles, with major implications for interest rates.

6. Should the rule or its inputs change based on economic conditions?
Says Mr. Taylor, "The Fed could change its strategy or deviate from it if circumstances called for a change." But now we're back where we started-a bunch of central bankers, with varying (and evolving) beliefs and biases, attempting to decipher ambiguous data and bandying about shaky forecasts. Only now, they'd do so in the context of wrangling over what the rule should look like and whether circumstances have changed.

7. How do we judge success?
It is impossible to test one rule's effectiveness versus another (or versus none at all), as there are no counterfactuals-no way to know how the economy would have performed under the exact same circumstances if the Fed had acted differently. If what works is always up in the air, members can easily fall back on their preferences and biases.

This is a long list, but it doesn't cover everything central bankers can disagree over^[i]-and this all assumes they love rules! So while in the abstract, the debate between rules-based and discretionary policy seems cut and dry, it's nearly impossible to separate them in practice. Besides, so much is outside the Fed's control-global interest rates, inflation, labor markets, any number of supply or demand shocks. Whether members prefer a rule, discretion, or pulling interest rates out of a hat, the Fed still can't micromanage the economy. So whoever Trump appoints, don't overrate their pro-rule or discretionary bias to mean much about where policy (or the economy) is heading. And, anyway, there is a long history of new Fed heads taking Martin's little pill^[ii] and forgetting everything they knew before accepting the post.