Some things, apparently, never go away. One of those things is the “Taylor-Rule.
Alan Blinder started off the latest debate in an op-ed in the WSJ:
Worse things are on the horizon. Two related proposals that failed in the 113th Congress are slated for a comeback in the 114th. Each would encourage congressional meddling with monetary policy.
The first is the Federal Reserve Accountability and Transparency Act, a bill introduced by House Republicans that has little to do with the worthy goals in its title. The objectionable part of FRAT, as I’ve written in these pages, would require the Fed to adopt a mechanical rule for monetary policy—it strongly suggests a rule invented by economist John Taylor of Stanford University—and then justify any substantial departures from that rule to Congress. The political message is unmistakable: Depart from the Taylor rule at your peril.
John Taylor, not surprisingly, “tones it down”:
Alan Blinder has written another Wall Street Journal article criticizing legislation that would simply require the Fed to describe its rule or strategy for monetary policy. As with his earlier article, Blinder still “shoots at a straw man of his own making, not at the proposed law itself” as I wrote in another John Taylor’s Reply to Alan Blinder for the Wall Street Journal.
Blinder says the act “would require the Fed to adopt a mechanical rule for monetary policy.” No, there is nothing mechanical about what is required. The legislation emphasizes that it is the Fed’s job to choose the rule and to describe the rule, and it can do so as it sees fit.
But then, Tony Yates and Paul Krugman intervene.
According to Krugman:
Since they aren’t currently able to demand a return to the gold standard — and maybe a ban on paper money? — Republicans are pushing to mandate that the Fed follow the so-called Taylor rule, which relates short-term interest rates to unemployment (and/or the output gap) and inflation. John Taylor, not surprisingly, likes this idea. But it’s a really terrible idea, and not just for the reasons Tony Yates describes.
You see, we had this thing called the Great Recession, whose aftereffects are still very much with us. And you would think we should learn something from that experience.
The Taylor rule came into prominence during the Great Moderation, and for around 15 years that very moderation, which most monetary analysts expected to persist into the indefinite future, was widely viewed as vindication for the rule. But the future isn’t what it used to be. The comfortable outlook in which Taylorism flourished has proved to be a mirage, and it’s hard to see why we should want to impose a policy that has totally failed to deliver on its promises.
Specifically, during the heyday of the Taylor rule the general belief was that the zero lower bound was a minor issue as long as we had a little bit of expected inflation.
But here we are, with the Fed funds rate still close to zero 25 quarters after the fall of Lehman, and expected to stay there for at least a couple more quarters, which means that the ZLB will have been binding more than 25 percent of the time since inflation dropped to around 2 percent in the early 90s. The world has turned out to be a much more dangerous place than Taylor-rule enthusiasts imagined, so why impose a rule devised, we know now, by economists who completely misjudged the risks?
Now Taylor himself has an excuse and rationale: he claims that the whole financial crisis thing was because the Fed departed slightly from his version of the rule in the pre-crisis 2000s. But as Yates points out, this assigns an importance to monetary policy that is wildly at odds with the kind of modeling used to justify the rule in the first place. It also, as Yates does not point out, has the distinct whiff of someone inventing ever-more bizarre stories to avoid admitting having been wrong about something. This is not the kind of argument on which to base rules that permanently constrain policy.
And Tony Yates rejoins with “Did John Taylor get us stuck at the ZLB?”
Paul Krugman picks up on my post about proposed legislation to get the Fed to pick a policy rule. The legislation is being championed by John Taylor because he thinks that the reason we got into this mess was because we deviated from his rule.
It’s interesting to wonder whether in fact the truth is the reverse.
Was it the sticking to the rule, rather than deviating it, which got the Fed trapped at the zero bound? That’s one way of reading PK’s post.
At the end, Yates writes:
In so far as monetary policy was at fault, the problem was that it was directed at a rate of inflation that with hindsight was just too low. Hence why I and others, PK and Blanchard included, have argued for a higher inflation target in the future. In the long run, higher inflation means higher central bank rates, one for one. And this means fewer and less severe episodes at the zero bound.
Some comments: Krugman implies the “Great Moderation” was a “mirage”. I think “living in fantasy” for more than 20 years is not reasonable. The “fantasy” was in believing the “Taylor-Rule” was the “kingpin”.
This idea captures well what was (is) wrong about NK views on monetary policy: “this assigns an importance to monetary policy that is wildly at odds with the kind of modeling used to justify the rule in the first place”.
Tony Yates´ attempt to turn things on its head, giving the Taylor-Rule “negative power” is outlandish. And suggesting a higher inflation target is the solution is, well, “silly”.
I thought that four years ago I had given the “closing arguments” on the Taylor Rule. Then I wrote:
Recently I posted an exceedingly long piece criticizing interest rate targeting, so I won´t go over that. But John Taylor insists in thinking that his namesake rule is the world´s 8th wonder, being the cause of all evil when it was “discarded”.
His latest post draws on a new study that questions justifications for quantitative easing. According to Taylor:
“Proponents of Quantitative Easing frequently cite—inappropriately in my view—the Taylor Rule as support, saying that the rule calls for a federal funds rate as low as minus 6 percent, well below the zero bound. But in various pieces over the past year, such as Taylor Rule Does Not Say Minus 6 Percent, I have argued the contrary. If you simply plug in current inflation and output (gap) you will find that the interest rate is above zero with the policy rule coefficients I originally derived. But QE II proponents change the coefficients. Frequently they use a higher coefficient on output (around 1.0) rather than the lower coefficient (0.5) which I originally recommended. The higher coefficient on output gives a much lower interest rate now and is thus used by proponents of quantitative easing.
A new paper by Alex Nikolsko-Rzhevskyy and David Papell provides important evidence relevant to this debate. They show that, if history is any guide, the higher coefficient would lead to inferior economic performance compared with the original coefficient I recommended.”
The operative words are: “if history is any guide”. Unfortunately history ceases to be a guide when you create a “whole new world”. And that´s exactly what the Fed did when it allowed nominal spending (AD) to completely “derail” (to paraphrase Taylor´s “Getting off track”). The “interest rate tweaking”, harmless enough when the economy was “on track”, proves quite useless, no matter the “parameter values” you plug in, when a derailing takes place. At this point the “target” should be to put the “train” back on the “track”. For that a new set of “tools” is required. But the main thing to do is “define the target”. And obviously since you´ve veered far “off track” when you “derailed”, a “level target” should be your goal. Until you get back “on track”, forget about “targeting rates”. They´ll only succeed in keeping you (far) away from the right “track”.
“Photograph shown at the inquest”