The Rule the Fed Needs Is a Margin I Already Collect

Darryl is a mold operator in the plastic-injection plant I own outside Muncie — 47, runs a 400-ton press on a 12-hour rotating shift, $16.40 an hour, no ventilation crediting the styrene fumes to the overhead line. The mold he cycles produces the housing for the thermostat you mounted yourself last spring. The ACGIH threshold limit for styrene is 20 parts per million over an 8-hour weighted average. The air-handling system that would keep the floor below that threshold was quoted at $73,000. I left the bid in the draft folder. The $73,000 stays in the operating account. The styrene stays in Darryl. The margin on the housing is $0.47 per unit. God keeps the covenant.

Jeb Hensarling wrote in National Review this week that the Federal Reserve should adopt a monetary policy rule — systematic, predictable, anchored to a defined reaction function so the public can count on the Fed to do “Y” when “X” occurs. Hensarling wants the rule. I want the same rule, for different reasons. Let me show you what the rule is worth to the man who keeps the deviation.

The rule he wants is the rule I already follow. The Fed’s discretion is a cost to me. When the funds rate sits at 5.5% and the Taylor Rule would have prescribed 7.25%, depending on the parameterization, I price my capital at the lower figure and pocket the difference. When the Fed keeps rates at 0 to 0.25 long after growth rebounds, I borrow at zero and lend through SwiftCash at 400% effective APR, and the deviation is a margin I’ve already collected. The rule Hensarling wants would make that deviation predictable. Predictable is better. Predictable means I can price the margin before the meeting.

Let me show you what regularity costs when you’re the one being regularized.

The Great Moderation, from 1982 to 2003, was the period when the Fed generally followed the Taylor Rule. Inflation ran between 2 and 3%. Inflation expectations were well anchored. The standard deviation of quarterly GDP growth fell by half. That was also the stretch when I could price a worker’s real wage decline with precision. A consistent 2.5% inflation means a worker’s purchasing power erodes by a known amount every year, and I can set the wage increase below that rate by a known margin, and the worker feels the erosion as a slow, predictable dullness rather than a shock that sends him to the unemployment line. Discretionary inflation is volatile. Rule-bound inflation is a schedule. I prefer the schedule.

The prophet Jeremiah recorded the Lord’s covenant with the day and the night (Jeremiah 33:20-21): “If you can break my covenant with the day and my covenant with the night, so that day and night shall not come at their appointed time, then also my covenant with David my servant may be broken.” Regularity is the divine signature. The Fed should learn from the creation. A rule followed 80% of the time — Hensarling’s own figure — would yield more predictability than the pure discretion that has produced the deviations I’ve already priced into my capital structure.

Here is the part the op-ed did not print.

Count the business schools. Count the graduating classes. Count 30 years of them. The economist who drafted the deviation analysis for the last FOMC meeting sat in my seminar 4 years ago, third row. He ran the Taylor Rule faster than I did. He saw the gap between the rule and the actual rate, and he priced the difference into the fixed-income desk he now manages. I cured him of the sentiment that the Fed’s discretion is a public good. By spring he saw the differential as a margin to capture. I say that with a teacher’s pride. The person who wrote the forward-guidance language Warsh is retiring also took a version of my course. The syllabus I assign — Social Obligations for Profit Maximization, third edition, the chapter on central-bank independence as a mispriced asset — is used in forty programs besides my own. You’re not reading the diary of a monster. You’re reading the faculty handbook, and the Fed’s staff economist has a copy.

The rule Hensarling wants will be adopted. It will be a variant of the Taylor Rule. It will be followed 80% of the time. The 20% deviation will be the only discretion the Fed retains, and that discretion will be exercised precisely when the rule would require a rate that cuts into the margin of the firms that fund the Fed’s reappointment. The deviation will be predictable by its beneficiaries. I’m one of them.

Darryl’s 12-hour shift on the 400-ton press earns the plant $0.47 per housing unit. The Fed’s rule, once adopted, will let me price that $0.47 with actuarial precision. The rule eliminates the uncertainty that keeps me from borrowing against the next 10 years of margins. I can securitize the predictable erosion of Darryl’s real wage. The 20% deviation will be predictable by the time it arrives. I’ve already priced it. The styrene stays in Darryl.

Sterling A. Varice holds the Hayek-Friedman Chair and serves as Dean of Instruction at Warden University’s College of Business and Economics in Richmond, Virginia. He is the author of three textbooks: Divine Mandates for Labor Utilization, Social Obligations for Profit Maximization, and Calibrated Deprivation: A Manager’s Guide to Employee Motivation.