The whole discussion seems to revolve around the fact that the solution to the economic problem is a simple question of “plugging the right parameter values”. One can only wish!
First, the speech indicates that I proposed two different policy rules for the federal funds rate, one in a paper published in 1993 and the other published in 1999. As Janet Yellen puts it, “John Taylor has proposed two simple and well-known policy rules.” She then goes on to consider what she refers to as the Taylor (1993) rule and the Taylor (1999) rule. However, I did not propose or advocate another rule in 1999, as I emphasized after similar statements were made at a Senate Banking Committee hearing with Ben Bernanke in March of last year.
In the 1999 paper which Janet Yellen refers to, I did examine two rules: one which I described as the “policy rule I suggested” and another which I said “others have suggested.” The “others” were people at the Fed, and I did not propose this other rule. It is important to correct the record because the “others have suggested” rule has a much larger coefficient on the GDP gap and is therefore more likely to generate zero interest rates now and be used to rationalize quantitative easing.
Second, in the graphs contained in the speech Janet Yellen has the Taylor rule showing the funds rate at zero or below now and for quite a while longer. But if you assume inflation of 2 percent, the Taylor rule implies that the funds rate should be 1 percent even if you assume an output gap of negative 6 percent. (1 = 1.5X2 + .5X(-6) + 1). The implied rate is higher for a smaller gap of 4 percent.
It´s been known for a long time that interest rates are an inadequate indicator of the stance of monetary policy. Nevertheless Yellen insists on relying on them, in addition to having to estimate deviations of output from “potential”, or unemployment from the “natural” rate:
Moreover, given our statutory mandate of maximum employment and price stability, it seems reasonable to focus on rules that mirror these two objectives by prescribing how the federal funds rate should be adjusted in response to two gaps: the deviation of inflation from its longer-run goal and the deviation of unemployment from my estimate of its longer-run normal rate. In my view, rules specified along these lines can serve as useful benchmarks for gauging the stance of policy and for communicating with the public about the rationale for our policy decisions.
Interestingly, for more than a decade there has been much discussion around the question of how to conduct monetary policy in a low inflation environment. What this tells me is that the inflation target goal, pursued through targeting the Fed Funds rate is not robust, with those involved in the debate being afraid of interest rates becoming “dangerously low”, which is exactly what happened.
A natural reaction has been, as proposed by, among others, Blanchard, Rogoff, Mankiw and Krugman, that a higher inflation target be set. If you only take a minute to think about the collateral effects of such a proposal you will surely keep your mouth shut!
Mysteriously, while the “solution” has been staring in everybody´s face, few have taken the step to propose it. Bear with me. If all the nasty things that are evident – the high unemployment rate, the low employment-population ratio, the low labor force participation, among several activity LEVEL indicators – can be traced to the “unusual” drop in nominal spending (NGDP) that occurred after mid-2008, why not set a nominal spending level target?
After all, that´s surely under the control of the Fed. But no, the Fed keeps indicating that things will remain “awful” for an extended period of time, and that´s why rates will be kept low going into 2014 or even 2015!
And if “awful” is what you are content with, “awful” will turn into a permanent feature of the US economy. In other words, “jobs, farewell”!