Risk Latte - Does Brainard's Principle matter anymore to the U.S. Central Bankers?

Does Brainard's Principle matter anymore to the U.S. Central Bankers?

Rahul Bhattacharya
March 20, 2008

For the last twenty years and until very recently the world had become used to seeing the Federal Reserve Bank hike or cut short term interest rates in an incremental manner. Many in the financial markets had nicknamed Alan Greenspan as "Mr Quarter Point" for his approach to increasing or slashing the short term interest rates in the U.S. It was always 25 basis points at a time, up or down.

All that changed when Ben Bernanke lowered the rates by 75 basis points in one shot in late January this year.

A lot has been talked about Brainard's principle and its impact on Central Bank's policy making in the U.S., both in the academic journals and speeches as well as in financial media recently.

Brainard's principle states that monetary policy should exhibit conservatism in the face of uncertainty. In a classic article in 1967 William Brainard showed that when policymakers (read Central Bankers) are unsure of the impact that their policy will have on the economy it would be preferable for them to adjust policy more cautiously.

What we have understood from our reading of the paper and other research material on this subject is this: the Brainard's principle says that if the policymaker - the central banker - is faced with an uncertainty about the future state of the economy and is unclear how his response to the current state will impact the future state of the economy he should adopt a method of gradualism with respect to monetary policy. He should incrementally change his policy and see what impact that produces, learn from that and then alter his policy if need be, or continue with the same policy in smaller steps.

We would like to refer the reader to Ben Bernanke's speech* on the subject in May 20, 2004. The speech also illustrates the principle with an interesting example from real life. Given his current policy actions, it seems that Chairman Bernanke has thrown the Brainard's principle out of the window.

A few questions remain in our minds. Is Brainard's principle a Bayesian approach to decision making? Did Alan Greenspan, the quintessential "Mr Quarter point" adhere to Brainard's principle in Toto? Was Greenspan's theory of risk management at Central Banks somehow tied to the Brainard's principle?

It is also interesting to note that Brainard's paper was published in 1967, a few years before the advent of the inflationary - or the "stagflationary" - decade of the seventies; a decade in which, according to some prominent minds, the policy making by the U.S. Central Bank went horribly astray. In retrospect one feels curious about whether Arthur Burns or his team at the U.S. Federal Reserve Bank then, paid any attention to Bill Brainard's paper.

* http://www.federalreserve.gov/boarddocs/speeches/2004/200405202/default.htm

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