In a recent post, Taylor writes:
Hundreds of research papers have been written on the nature and causes of the Great Moderation, which got started around 1983. While that research began long after the Great Moderation got underway (I published one of the earliest papers on it in 1998), we should not wait so long to start seriously researching the causes of the post-Great Moderation period, regardless of how this period is eventually named by economists.
In my view, the framework that Ben Bernanke used in a February 2004 paper to study the causes of the Great Moderation is a good one. It goes back to research that started before the Great Moderation. Bernanke characterized the Great Moderation as a reduction in (1) the variance of inflation and (2) the variance of real GDP. He used the following diagram (it is a replica of Figure 1 in his paper) in which these two measures are on the horizontal and vertical axes respectively. Using the diagram he represented the Great Moderation as a move from point A to point B. He showed that a primary cause was better monetary policy, and he represented this by showing that better policy brought the economy closer to the true policy tradeoff curve (TC2) rather than the occurrence of a shift in the curve (from TC1 to TC2) . I completely agree with that interpretation.
But what caused the end? I have updated Bernanke’s diagram by adding a point C and a line from point B to point C (in red), based on the empirical volatility measures in the table below for the three periods. Observe that the post-Great Moderation deterioration does not simply retrace the previous improvement. It is nearly vertical, reflecting that virtually all the deterioration is in the output variability dimension.
In my view monetary policy was a major factor in the end of the Great Moderation just as it was the major factor in the Great Moderation itself. I review the reasons for this view in this paper on central bank independence versus policy rules which I am presenting at the annual meeting of the American Economic Association next month.
In the paper he says:
It was through such considerations that Bernanke (2004), Taylor (1998, 2010), Meyer (2010) and others were led to consider changes in monetary policy as a major reason for the improved economic performance in the 1980s and 1990s. And in fact there were clearly identifiable changes in policy during this period, including the more rule like focus on price stability and the closer adherence to simple predictable policy rules starting with Paul Volker and continuing for much of Alan Greenspan’s term.
In my view, the same monetary policy considerations—working in reverse—are relevant for explaining the recent deterioration of performance. Monetary policy became much less rule like, starting in my view in the period from 2003 to 2005 when the policy interest rate was held far below levels that would have pertained in the 1980 s and 1990s under similar conditions.
If he can insist on blaming rates “too low for too long” in 2003-05, I can insist it wasn´t. In fact, during that period monetary policy was the correct one. As soon as in August 2003 the FOMC said that:
The Committee perceives that the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. In contrast, the probability, though minor, of an unwelcome fall in inflation exceeds that of a rise in inflation from its already low level. The Committee judges that, on balance, the risk of inflation becoming undesirably low is likely to be the predominant concern for the foreseeable future. In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period.
The economy began to mend. By “mend” I mean NGDP began to rise towards trend and all the things we would be happy to see happen now – increase in RGDP growth, rapidly falling unemployment, rising long term rates, increase in stock prices and rising inflation expectations – happened then!
But note that “monetary policy was the correct one” given there was no explicit target stated. If, for example, that Fed had an explicit NGDP level target, quite likely interest rates would not have stayed “so low for so long”. Differently from Taylor, I believe the problem lies not in the “Taylor rule” not being “practiced” but in the absence of an explicit nominal (preferably NGDP) level target.