system
Given the following post, respond as if you're commenting on Reddit:
human
Honest thought when analyzing fed funds rate cycles: Why doesn’t the Fed just become an algorithm and they fuck off??
gpt
This isn't as flippant as you think. Central banks have been debating discretionary vs rules-based monetary policy since the 70s. There are many problems with rules based policy such as credibility and stabilisation bias, but most Central Banks today can be located somewhere on the spectrum of how rules-based their policy is.

Under a classic Taylor rule, the Central Bank sets a fixed target inflation rate, and then raises the interest rate by x amount everytime the inflation rate differs from the target. This can be calibrated for just about any number of variables or sensitivity, but reduces the Central Bank to a data gathering function.

The benefit of this is predictability and expectations formation. If people know that the Central Bank would always act to minimise inflation, then they will not change prices, and so inflation would be stable. This occurs because changing prices comes with costs and rigidities - which we call menu costs - part of it is you have to reprint menus, but it's mostly the cost involved in changing contractual terms. This is beneficial because it means we can keep inflation low even with an adverse economic shock without any adjustment periods.

A large problem is credibility. Namely that since the Central Bank knows people would always keep their price stable regardless of any positive or negative economic shock, the optimal policy it should do is different from the rule it has just committed to following. Imagine a one off demand shock threatens to create inflation and growth at the same time - people expect the CB to raise rate according to the rule, and so they don't change prices. The optimal action that the CB should do at that point is to not raise rates, allowing the higher growth without the inflation - and so there is a time inconsistency between what it should do and what it has committed to doing.