But the House Republicans have other ideas. They seem to think the big problem is inflation. Therefore they are proposing the “Federal Reserve Accountability Act.” One of the major items in the Act is a requirement that the Fed follow a Taylor Rule in setting its monetary policy. As specified in the bill, the Fed would be required to set the federal funds rate at a level determined by the gap between potential GDP and actual GDP and the gap between the current inflation rate and the 2.0 percent target inflation rate. The law is intended to sharply limit the Fed’s discretion in adjusting monetary policy to the state of the economy.
There are both technical problems and substantive problems with this approach. On the technical side, the Act doesn’t give guidance as to what the Fed should do when the Act’s formula implies a negative interest rate, as would have been the case at least in 2009 and 2010 when the economy was operating at more than 10 percent below its potential.
The other major technical problem is that potential GDP is poorly measured as evidenced both the large differences between estimates from the OECD, the International Monetary Fund (I.M.F.), and the Congressional Budget Office (CBO). It’s not uncommon for these estimates to be 2-3 percentage points apart. For example, the I.M.F. currently puts the U.S. economy at 3.2 percentage points below potential, while CBO puts the shortfall at more than 5 percent of potential output.
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