Monetary policy is about precisely measuring the state of the economy and then mechanically setting the correct interest rate. In that sense, the conduct of monetary policy should rely more on strict scientific rules and less on human judgement.

Monetary policy refers to the tools and actions that the monetary authority of a state uses to accomplish broader economic and societal goals. In the United States, the Federal Reserve is directed by Congress to pursue maximum employment, stable prices, and moderate long-term interest rates – also known as the “dual mandate”. Prior to the 1980s, the Federal Reserve’s primary method to influence the dual mandate was to manage the total quantity of reserves in banks – thus indirectly affecting overall money in the economy. However, for the past four decades, the Federal Reserve transitioned from influencing overall financial aggregates to controlling the federal funds rate or interest rates. While mechanically setting a correct interest rate based on the state of the economy is possible in theory, in practice, there is no adequate mechanism that comprehensively evaluates the state of the economy. In addition, the very act of communicating monetary policy to the public influences the future of monetary policy; human nature and psychology of how people will behave must be taken into account. To this end, monetary policy should utilize all presently available scientific data with the understanding that it is imperfect data and human judgement will also affect monetary policy in the future. 

The goal of moderately influencing long-term interest rates is primarily concerned with controlling inflation in an economy. The standard view of economic policy suggests that as interest rates are raised: borrowing, hiring, investing, and spending decreases and inflation also decreases. The inverse of this idea is also true. As interest rates are lowered: borrowing, hiring, investing, and spending increases which all stimulate the economy and over time lead to a higher rate of inflation. By changing the interest rate paid to banks holding reserves at the Federal Reserve, the Federal Reserve directly influences inter-bank interest rates (federal funds rate) and the interest rates that eventually pass down to consumers in the economy. Through this mechanism, the Federal Reserve is able to balance inflation and deflation to acceptable levels through increasing and decreasing market interest rates. 

Keeping the above standard view in mind, there are certain scientific rules that have been established to act as guidelines for the Federal Reserve. One of the most popularized rules is the Taylor Principle, “which tells central bankers to raise interest rates by more than inflation has gone up”¹. To explain this principle further, the Fisher equation lays out the relationship between interest rates and inflation:

Real Interest Rate = Nominal Interest Rate – Expected Inflation

The nominal interest rate is what the central bank sets while the real interest rate is what consumers are actually paying when we take into account inflation over the same time period. Given a state where central bankers have omnipotent access to the exact state of the economy, they may be able to divine the exact nominal interest rate necessary to be greater than expected inflation and properly hedge the economy against actual inflation. But here lies the first major problem with only using scientific data. It is impossible to get an accurate assessment of actual inflation and consumer spending at any point in time. In an economic system as big and dynamic as the United States, any data received on the state of the economy is an outdated estimate lacking in 100% accuracy. In light of this, it is important for central bankers to often take an overly conservative course of action (i.e. perhaps setting interest rates higher than they need to be) in order to not create a perfect economy, but to better avoid the risks of uncontrolled inflation or deflation. The goal becomes not optimization, but avoidance of an economy that spirals out of control. 

While forecasting into the future should play little part in policy decisions by central bankers, a defined goal of the future is essential to the socioeconomic psychology of a state. If this sounds vague, it is purposefully so. There is a reason that federal bankers have been dubbed the high priests of the economy who must rely not just on data, but on careful rhetoric and direction to steer an economy. As an example, the United States has used an inflation targeting system of 2% for the last few decades. This average of 2% is consistent with upwards trends in consumption, leaves wiggle room for the federal reserve to lower and raise interest rates, and perhaps most importantly, gives the public an idea of what the future holds. Imagine if the fear of uncontrolled inflation permeated the subconscious of a society to a depth and breadth that was irreversible. Hoarding and decrease in spending would spread and inflation would increase. That state would spiral until its financial system ceased to matter. The central bankers are responsible for properly governing the faith and rational expectations that people have for the future. 

All this together, when central bankers use different tools to influence monetary policy they must use all scientific metrics at their disposal to best understand the nature of the society they are manipulating. In this endeavor, they must also keep in mind that they are dealing in a human system that does not operate with perfect information, nor with perfect rationality. Monetary policy should fundamentally hope to avoid catastrophe and implosion, and resist the temptation to build a framework that creates a perfect economy.

Footnotes
1. “Interest rates have risen sharply—but is monetary policy truly tight?” The Economist, November 10, 2022. Accessed October 13, 2025. https://www.economist.com/finance-and-economics/2022/11/10/interest-rates-have-risen-sharply-but-is-monetary-policy-truly-tight