Why waste time with Taylor-Rules?

That´s what Simon Wren-Lewis does in “Taylor Rules, the ZLB and Euro Diversity”:

John Taylor originally suggested his rule as both a good guide to what central banks actually do and also one that “captures the spirit of the recent research”. It has been used ever since as a yardstick by which to measure monetary policy. However there are well understood reasons why it is likely to be a poor yardstick in a severe recession.

However the Breugel post is not really about how appropriate the ECB’s monetary policy is for the Eurozone as a whole. Instead it focuses on what the rule tells us monetary policy might have been in each individual Eurozone economy, if they had retained their own currency and had floated. Or to put it another way, it tells you for which countries the ECB’s policy is too tight, and for which it is too easy. Used in this way, the analysis is a handy way of combining information on inflation and unemployment diversity across the Eurozone.

Where is the ECB’s policy too tight? There are the obvious countries: Spain, Portugal, Italy and especially Greece. But there is another, which is the Netherlands. There is no mystery here: CPI inflation is currently (May) 0.8%, the harmonised rate is 0.1%, and unemployment has been over 7% this year, compared to an average of below 4% from 2000 to 2007. As the Netherlands does not have an independent monetary policy, it desperately needs a countercyclical fiscal policy, yet instead it is locked into the austerity trap imposed by the Eurozone’s fiscal rules. All of this was horribly predictable, which is why I wrote these posts: May12, Sept12, June13, Dec13.

In fact, ECB monetary policy has been tight almost all over, exceptions being Germany and Austria. The charts pick on Holland and Spain (representative agents for the “core” (ex-Germany and Austria) and “periphery”, respectively.

ECB Mistake_1

It is clear that the rate increase by Trichet in April and July 2011”broke the trend” in Holland and made the situation even worse in Spain. No wonder inflation is in free-fall and unemployment on the rise.

And what the next chart makes clear is that the macro adjustment among “core and periphery” has fallen exclusively on the “periphery”, with the “periphery” having to undertake all the current account adjustment with no “helping-hand” from the “core”, which has maintained its CA surplus intact!

ECB Mistake_2

3 thoughts on “Why waste time with Taylor-Rules?

  1. A “one size fits all” monetary policy for Europe is a failure.

    The Taylor Rule is an interesting idea—but what does it say when we hit ZLB recession? We cannot have negative interest rates.

    I also wonder about the Taylor Rule in a world of capital gluts.

    The usual right-wing response to capital gluts is to say they cannot exist. But today we have globalized capital markets and many nations have “forced savings” such as China, Japan, much of the Mideast (sovereign wealth funds). People globally buy insurance to cover their assets regardless of rate of inflation, and then insurance funds build huge pools of capital. Then you have pension funds under obligation to build assets, regardless of interest rates.

    So if inflation is kept under 2 percent, then we can expect to see interest rates at or near zero. Savers have to take losses. When free markets are glutted, then sellers take losses, and sellers of capital must take losses now. There is more capital than the market wants.

    Raising interest rates may be impossible, and even if done (temporarily) will only discourage consumption and increase savings—worsening the glut.

    Then you have the problem of a central bank trying to tighten its way to higher rates. You can do that for a while, but as Milton Friedman noted, sooner or later that leads to lower rates. Tight money=low rates.

    So the Taylor Rule may be useless now, unless it is adjusted to recognize capital gluts and also factors in some sort of QE. That is, “When inflation is below 2 percent, and tea; GDP growth under 3 percent, the central bank must do $50 billion in QE monthly,” or something to that effect. in other words, the Taylor Rule is modified to require QE at certain levels (or lower IOER).

    I would prefer MM.

  2. Pingback: Why waste time with Taylor-Rules? | The Corner

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