After all the hoopla about NGDPT that happened over the last several weeks, with “endorsements” from Christy Romer, Paul Krugman, Goldman Sachs and The Economist, among many others, I wondered when John Taylor would come out to defend his namesake rule.
He just did in this post (my bolds):
One change is that, in comparison with earlier proposals, the recent proposals tend to focus more on the level of NGDP rather than its growth rate. This removes some of the instability of NGDP growth rate targeting caused by the fact that NGDP growth should be higher than its long run target during the catch up period following a recession. But it introduces another problem: if an inflation shock takes the price level and thus NGDP above the target NGDP path, then the Fed will have to take sharp tightening action which would cause real GDP to fall much more than with inflation targeting and most likely result in abandoning the NGDP target.
Rules for the instruments are what monetary policy needs, not excuses for discretionary actions. I welcome more research looking for better instrument rules which are explicit and operational enough to be evaluated with empirical economic models. Even an historical comparison of different rules would be welcome, and Allan Meltzer’s monumental History of the Federal Reserve would be a good foundation to build on. As he summarized in a speech this week, “Economists and central bankers have discussed monetary rules for decades. A common response of those who oppose a rule, or rule-like behavior, is that a central banker’s judgment is better than any rule. The evidence we have disposes of that claim. The longest period of low inflation and relatively stable growth that the Fed has achieved was the 1985-2003 period when it followed a Taylor rule. Discretionary judgments, on the other hand, brought the Great Depression, the Great Inflation, numerous inflations and recessions. The Fed contributed to the current crisis by keeping interest rates too low for too long.”
Since I sent the link to Taylor´s post to Scott Sumner, I believe he´s going to do a post. In that case I´ll be brief, referring my readers to a (long) piece that I wrote in early in 2010 (and posted last May) on the “dangers” associated with interest rate targeting (Taylor Rule), arguing, inter alia, that the Fed did not carry on (as pointed by Taylor) an excessively expansionary MP (“too low for too long interest rates”) after the 2001 recession which, according to Taylor and many others, paved the way for everything bad that happened, from high prices at the pump and at the supermarket all the way to the housing crisis and finally the financial crisis.
Regarding Taylor´s claim that “if an inflation shock takes the price level and thus NGDP above the target NGDP path, then the Fed will have to take sharp tightening action…” that is quite wrong. An inflation shock following, for example, an increase in oil prices would raise prices and reduce real output, keeping nominal spending more or less unchanged. If nominal spending was evolving along the target path before the shock, the Fed shouldn´t react to it. The same would be true for a drop in inflation due to a productivity shock. Prices would fall and real output rise, requiring no reaction from the Fed. Actually, in the examples described, if the Fed reacts to these “inflation shocks” it will cause instability. And if the Fed is following a Taylor Rule to target inflation, that´s exactly what it will do!
Update: Scott obliged!