There is a long-running debate as to whether macroeconomic policy decisions should follow predefined rules or be left to the discretion of benevolent and informed policymakers.
This article focuses on the reasons and risks behind the popularity of rules-based macro policy, concentrating on monetary and fiscal policy. While there is a vast literature analyzing the causes, effects, design choices and institutional setting and some have underscored the relationship between both in actual experience, it is not common to look at them in a comparative fashion.
Monetary Policy
Many central banks have adopted inflation targeting regimes (IT), in which price stability is set as the main policy goal, so much so that there is an explicit target for the inflation rate (a policy rule). Under this regime, monetary policy is completely oriented to the achievement of the target.
For IT to work, it is not sufficient to announce the target and expect that everyone will believe in it. Indeed, the right institutional setup is an important as the target itself, if not more so. IT does not mean that the Central Bank has to abide by the rule at all times and under any circumstances and may choose to deviate from this path. This typically happens in two circumstances. First, since inflation measurements are likely to include a number of short-term disturbances, most IT focus on medium-term forward-looking inflation (“forward inflation targeting”).
Second, some central banks have dual mandates of price stability and “economic prosperity”, providing a good-enough reason for which central banks may choose to depart from pure IT, so long as the price stability objective is not compromised in the medium term.
Fiscal Policy Rules
Fiscal rules are more recent and heterogeneous, both in their formal definition as well as in their implementation, and compliance is usually less strict. There is less consensus on what the “right” fiscal rule is, and each country has adopted the rule that fits better with its institutional, political, and economic needs and constraints.
The IMF defines a fiscal rule as one that “imposes a long-lasting constraint on fiscal policy through numerical limits on budgetary aggregates.” Fiscal rules can be good for the economy, provided they are well defined and stable, and that the institutional setup of the country is strong enough to ensure compliance. There is always concern that rules may limit the ability of policymakers to react to large and unexpected shocks, aggravated by the fact that it is usually when these shocks hit that countercyclical fiscal policy becomes a crucial stabilization tool. To provide some flexibility, fiscal rules may consider exceptions for extreme circumstances too.
Deconstructing Macro Policy Rules
To better understand the challenges in designing, implementing and attaining macro policy rules, it is useful to examine their six-component architecture:
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1. An underlying measure/indicator that provides the basis for the rule. For instance,
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Monetary: indicators such as current, core, or expected inflation measures,
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Fiscal: rules based on a debt level, structural or cyclically-adjusted balance, or a spending rule.
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2. A numerical target, indicating the value of the measure to be attained, including its time horizon. For instance,
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Monetary: a fixed inflation target or a band,
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Fiscal: a debt to GDP ratio or a structural budget as a percentage of potential GDP.
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3. A regular reporting mechanism to compare the actual value of the indicator versus the target.
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4. Accountability mechanisms, establishing rewards/penalties to policymakers when complying with/ departing from the target.
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5. Exception/escape clauses that allow to depart from the rule under exceptional circumstances.
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6. Convergence provisions, to organize the transition towards the target when departing from a distant position or to return to it after missing the target or resorting to an escape clause.
Why are Monetary Policy Rules more Complied with than Fiscal Rules?
Some factors may stem directly from design choice on the rule’s components as listed above. For instance, we noted that while monetary policy rules tend to be stated on end-outcomes closer politicians’ and public concerns, fiscal rules are generally geared to intermediate output, not reflecting citizens’ well-being. While it could be argued that the latter makes compliance easier, popular support and political commitment may be just the opposite.
Perhaps the greatest difficulties for fiscal rules originate in their complex political background, reflected in two dimensions: (i) goal congestion, as public finances are expected not only to meet macro fiscal objectives but also social areas of public policy; (ii) political time inconsistencies, as governments are likely to have a preference for immediate results as compared to longer-run benefits from fiscal discipline.
Lastly, coherence between monetary and fiscal rules matter more for macroeconomic outcomes of growth and price stability than each of them in isolation. In this sense, a fiscal rule that creates coordination difficulties or outright inconsistencies with a long-established monetary policy rule is likely to succumb more easily, no matter how well pursued.
Rather than interfering with public policy, macro policy rules should be seen as enablers of sustainable and effective public policies in education, health-care and infrastructure. If only for this reason, macro policy rules are worth the effort invested in designing and pursuing them.
Excerpt from Marcel, M. (2019), “Getting Rules into Policymakers’ Hands: A Review of Rules-based Macro Policy,” Economic Policy Paper 66, Central Bank of Chile.
