Fed Report Cautions on Hazards of Monetary Policy Rules -- Update

The Federal Reserve defended having the flexibility to set interest rates without new scrutiny from Capitol Hill in its semiannual report to Congress on Friday, warning of potential hazards if it were required to adopt a rule to guide monetary policy.

Fed Chairwoman Janet Yellen is set to testify on the report Wednesday before the House of Representatives, which last month approved on a party-line vote financial regulatory legislation that would require the Fed to set a mathematical rule guiding monetary policy-making and explain instances when it diverges from that rule. She will testify Thursday in the Senate, which doesn't appear likely to advance the bill soon.

The Fed's report didn't provide new clues about the immediate policy or economic outlook. The economy has largely performed in line with Fed expectations with two exceptions: Inflation has softened in recent months after it appeared to converge earlier this year toward the central bank's 2% target, and financial conditions have eased even though the Fed has now raised interest rates three times in as many quarters.

The Fed raised its benchmark federal-funds rate in June to a range between 1% and 1.25%. Officials have penciled in one more quarter-point increase this year, and they unveiled plans to begin slowly shrinking their portfolio of more than $4 trillion in Treasury and mortgage securities. The Fed said in Friday's report it expects to begin implementing the plan this year, in line with recent statements.

In Friday's report, the Fed weighed in on a long-running academic debate about the use of mathematical rules to guide monetary policy. The debate has taken on added urgency because House Republican lawmakers, who have been critical of the Fed's approach to keeping rates low in recent years, have advanced legislation that would require the Fed to more closely adhere to prescriptive rules in setting policy.

The House-approved legislation would require the Fed's rate-setting committee to adopt a policy rule and it would empower the Government Accountability Office, an investigative arm of Congress, to monitor compliance. While the Fed wouldn't have to follow the rule, it likely would invite greater political scrutiny of the bank's monetary policy decisions.

Advocates say that would make monetary policy more predictable, but critics say the rules could create new complications, particularly in an environment when interest rates are near zero.

"The U.S. economy is highly complex, and these rules, by their very nature, do not capture that complexity," the Fed report said.

Such rules, including one offered in the early 1990s by Stanford University professor John Taylor, are relatively easy to use and prescribe a tight relationship between a small number of economic data points and the setting of short-term interest rates. Fed officials say they regularly use such rules to guide their management of monetary policy but have warned against overreliance.

"Monetary policy rules do not take account of broader risk considerations," such as risks to financial stability, the report said. In addition, rules don't provide enough flexibility for asymmetric risks, for example, limiting possible responses to an economic shock when the federal-funds rate is close to zero.

"This asymmetric risk has in recent years provided a sound rationale for following a more gradual path of rate increases than that prescribed by policy rules," the report said.

The report also flagged significant differences between policy rules. "The pace of tightening that the rules prescribe has varied widely," the report said, with different rules proposing a federal-funds rate during the first quarter of anywhere from 0.37% to 2.5%.

Separately, the report said vulnerabilities facing the U.S. financial system remain moderate, with demand for higher risk from investors offset by strong capital positions for the financial sector as a whole.

Write to Nick Timiraos at nick.timiraos@wsj.com

(END) Dow Jones Newswires

July 07, 2017 14:32 ET (18:32 GMT)