Discretion versus Rules

Paul Krugman ponders which measure of inflation would be the best for central bankers to use when setting policy. Should it be headline inflation? Core inflation? Wage inflation? Some "supercore" measure of inflation? (I'm picturing it sitting at the FOMC meetings in a blue business suit with a discreet red cape.)

As I have done my own pondering on the subject, I keep coming back to the thought that really, none of those measures is adequate by themselves. Sometimes you need to pay attention to wage inflation, but sometimes you don't. Sometimes you need to worry about the headline rate, but sometimes you don't. In my view, it's the job of a good central banker to assemble lots of different types of data, develop a complete picture of the economy composed of many brushstrokes, and set policy accordingly.

In other words, I think that there's a good argument to be made for modifying the rules-based approach to monetary policy-making most central banks have tended toward over the past 10 or 15 years in favor of a more discretionary approach. I know, this is close to heresy in the world of monetary policy economics. But consider the strict rules-based approach of the ECB compared to the somewhat more discretionary policy-making approach of the Fed. Is it obvious to you that the ECB has been better at monetary policy than the Fed? No, it's not to me, either...

The main counter-arguments to a more discretionary approach to monetary policy-making are: (a) strict rules help to insulate central banks from political pressure to do the wrong thing; (b) rules help to anchor inflation expectations; and (c) in the absence of rules, if a central bank is unlucky enough to get a "bad" central banker, it will get "bad" monetary policy.

But (a) can happen equally in the presence or absence of rules. (B) is very well understood by now, central bankers know how important inflation expectations are, and those expectations are going to be based on the central bank's actual policies anyway, not the central bank's "rule". And (c)? Do you really want to argue that the quality of central bank policy-making has been irrelevant to the Fed or the ECB? A central bank can opt for bad rules just as it can opt for bad policies. And I think it's quite clear that some central banks do their job better than others, even when they are supposedly just following "rules".

To be even more explicit: I think that the Fed has done a pretty good job of monetary policy in recent years, while the ECB has not. So a bit of discretion has done better than a strict rules-based approach. And I don't think that's a coincidence.