Money Policy

New Fed Research Calls for Constraining Discretion in Setting Monetary Policy

With two new governors set to join the Federal Reserve Board, former member Frederic Mishkin of Columbia Business School outlines an alternative to the decades-old Rules vs Discretion debate

Jul 16, 2019 — NEW YORK, July 16, 2019 /PRNewswire/ — For nearly three decades, economists have long presumed that the Federal Reserve and global central banks must make a choice between setting a rigid monetary rule or taking discretionary action as economic conditions change. But new research by Columbia Business School’s Alfred Lerner Professor of Banking and Financial Institutions Frederic Mishkin, demonstrates that the two can coexist under a scenario known as “constrained discretion.”

As the Fed pursues monetary governance that ensures maximum employment, stable prices, and moderate long-term interest rates, the two policy options couldn’t be more different. A rule typically requires the Board to take actions – like interest rate changes – based on specific data like new employment numbers. But because a rule can be rigid and inflexible during unforeseen events like a terrorist attack or the 2008 financial crisis, some policymakers have called for the Board to avoid the limitations of rule-setting. A pure “discretionary” policy would mean the Board only takes action on an ad-hoc or a case-by-case basis.

Pushing back against political influence

Mishkin’s new research argues that a policy discretion approach can become more rule-like by adopting targets – such as inflation or an exchange rate, with a transparent communication strategy. According to the study, the mix of the two policies could be beneficial in pushing back against political influence and reinforce institutional independence. This research comes at a pivotal time as the Federal Reserve Board has two of its seven seats open, one of which carries a term through 2030.

“With the right kind of transparency, constrained discretion would allow the Fed to get the benefits of adopting a rule to focus on the long-term economic outlook while also enabling a lot of discretion,” said Professor Mishkin, a former member of the Board of Governors of the Federal Reserve System. “The extremes of either path have flaws, but finding a happy middle can give you the advantages of both.”

Mishkin’s study examines past policy mistakes by the Federal Reserve Board that led to big economic swings, from the Great Inflation of the 1960s and 1970s to the low inflation periods of the early 1980s, using them as examples of when rule adoption or discretion caused avoidable problems. Limitations of both policy approaches are outlined in the study, including a number of pitfalls with rule-making:

  • “It requires that the structure of the economy is stable.”
  • “Monetary policymakers are not less trustworthy than rules.”
  • “A rule intrinsically removes judgement, and it cannot foresee every contingency, including the subprime mortgage lending bubble of the mid-2000s.”

Constrained Discretion

His research also argues that by adopting a “nominal anchor” or economic target such as inflation, the policy of constrained discretion avoids the hazards that occur when policymakers use a purely discretionary approach. Constrained discretion utilizes the benefits of both a rule and discretion as it allows monetary policymakers considerable leeway in responding to economic shocks, financial disturbances, and other unforeseen developments while also making a strong commitment to keeping inflation low and stable.

The extremes of either path have flaws, but finding a happy middle can give you the advantages of both...

Additionally, Mishkin argues that central banks in the US and internationally must improve their communication with lawmakers and the public about how monetary policy would change as economic circumstances change. This includes by providing more information about their policy reaction process. This would lead to greater accountability and allow the public and markets to assess whether the policy is on track to achieve its goals, even before the results are revealed.

“Central banks continue to face criticism in the U.S. and in other major economies, with factions who regularly seek to roll back their independence,” said Mishkin. “Communication is critical for banks to respond to these threats and to relay to the markets how it intends to respond to changes in economic circumstances.”




To read the study, click here: Improving the Use of Discretion in Monetary Policy.
To learn more about the cutting-edge research being conducted at Columbia Business School, please visit