John Taylor was wrong, but so is DeLong

Brad DeLong writes “The Trouble With Interest Rates”, where he strongly and rightly critiques views of John Taylor and concludes:

There is indeed something wrong with today’s interest rates. Why such low rates are appropriate for the economy and for how long they will continue to be appropriate are deep and unsettled questions; they call attention to what MIT’s Olivier Blanchard calls the “dark corners” of economics, where research has so far shed too little light.

What Taylor and his ilk fail to understand is that the reason interest rates are wrong has little to do with the policies put in place by central bankers and everything to do with the situation that policymakers confront.

However, what DeLong fails to realize is that the “situation that policymakers confront” is closely tied to the policies that the central bankers put in place previously!

In the linked Blanchard article, written on December 1 2008, we read:

Third, governments must counteract the sharp drop in consumption and investment demand. In the absence of strong policies, it is too easy to think of scary scenarios in which depressed output and troubles in the financial system feed on each other, leading to further large drops in output. It is thus essential for governments to make clear that they will do everything to eliminate this downside risk.

Can they credibly do it? The answer is yes. With interest rates already low, the room for monetary policy is limited. But the room for fiscal policy is wider, so governments must do two things urgently. First, in countries in which there is fiscal space, they must announce credible fiscal expansions; we – the IMF – believe that, as a whole, a global fiscal expansion about 2% of world GDP is both feasible and appropriate.

Coincidentally, as Blanchard had just finished typing his words, the next day the Fed announced:

that it will extend three liquidity facilities, the Primary Dealer Credit Facility (PDCF), the Asset-Backed Commercial Paper Money Market Fund Liquidity Facility (AMLF), and the Term Securities Lending Facility (TSLF) through April 30, 2009.

I call that QE0 and in fact, according to our proprietary MAST Index, it marked the end of the financial panic!

What´s wrong with Interest Rates_1

Also coincidentally, soon after, on February 17, President Obama

signs into law the “American Recovery and Reinvestment Act of 2009”, which includes a variety of spending measures and tax cuts intended to promote economic recovery.

Even more coincidentally, the deficit quickly goes to the 2% of GDP suggested by Blanchard, and remains at that level for the next three years.

What´s wrong with Interest Rates_2

The panic ended and fiscal stimulus was introduced, but the real economy only began to improve when monetary policy, gauged by NGDP growth turned! Note that the removal of fiscal stimulus, which began in mid-2012, did not affect the NGDP growth-determined pace of the recovery.

What´s wrong with Interest Rates_3

Initially, going into the crisis, monetary policy was very tight. During the past five years, it has remained tight, even if much less so.

Note: The Market Advised Sentiment Tracker (MAST) tracks the coordinated movements of a basket of financial market prices. As such it will respond to rumors, statements by Fed officials or any unexpected asset price move. It is a proprietary index of NGDPAdvisers, a macro consultancy that will begin activities early next year.

“Last chance”…to get their act together!

Unfortunately, that´s very unlikely as seen here: “The Fed Strives for a Clear Signal on Interest Rates”:

Federal Reserve officials are widely expected to announce Wednesday that short-term interest rates will remain near zero, leaving mid-December as the central bank’s last chance to raise rates this year.

The timetable poses twin challenges for Fed Chairwoman Janet Yellen: Deciding whether the U.S. economy is ready for an interest-rate increase, and signaling central bank intentions without causing further market confusion.

Mike Belongia and Peter Ireland have just published “The Fed Has Not Become More Transparent”:

We applaud the Fed’s willingness under Bernanke and Janet Yellen to announce publicly its commitment to a 2 percent inflation target and acknowledge the consistency of its statements regarding a balanced approach to stabilizing inflation and unemployment.  This information makes clear what the central bank hopes to achieve with its monetary policies over both intermediate and longer horizons.  At the same time, however, we join others in wondering whether the “lively debate” that continues to be evident in the frequent, but often conflicting statements of Fed officials clarifies or confuses what monetary policy is doing and why.

John Taylor agrees:

“I don’t really understand what is unclear right now,” said William Dudley, president of the Federal Reserve Bank of New York, during an appearance at a panel in Washington this month.

“Are you kidding?” Stanford University economist and Fed critic John Taylor said. “No one knows what you’re doing.”

John Taylor “celebrates” 30 years of the Plaza Accord

John Taylor:

That the dollar depreciated across the board—as much against the mark as against the yen—suggests that it was part of a general reversal of the dollar appreciation experienced during 1981-1985 due to the monetary policy strategy the Fed had put in place.  As Alan Greenspan put it in an FOMC meeting in 2000, “There is no evidence, nor does anyone here [in the FOMC] believe that there is any evidence to confirm that sterilized intervention does anything.”

The dates of the Plaza and the Louvre meetings are marked in the chart. Observe how the move toward an excessively restrictive policy starts at the time of the Plaza meeting. Indeed, as chart shows, the Bank of Japan increased its policy rate by a large amount immediately following the Plaza meeting, which was in the opposite direction to what macroeconomic fundamentals of inflation and output were indicating. Then, after a year and a half, starting around the time of the Louvre Accord, Japanese monetary policy swung sharply in the other direction—toward excessive expansion.  The chart is remarkably clear about this move. The policy interest rate swung from being up to 2¼ percentage points too high between the Plaza and the Louvre Accord to being up to 3½ percentage points too low during the period of time from the Louvre Accord to1990.

The highlighted sections denote “rubbish”. The dollar never appreciated relative to the yen in the years before the Plaza. It did so against the German DM. So you cannot say “it was part of a general reversal of the dollar appreciation experienced during 1981-1985…”

And God forbid what would have happened to the Japanese economy if between 1987 and 1990 the BoJ had followed the “Taylor-rule”! As we now know, that was the time that Japanese NGDP flattened out and Japanese real growth all but disappeared!


The fact is that Japan could never let the yen depreciate relative to the dollar. It could and should appreciate! The initial rise in the BoJ´s call rate was to make sure that happened.

The “Rules debate” once again

In Time Inconsistency Is Only One of Many Reasons to Favor Policy Rules John Taylor writes:

Advocates of purely discretionary monetary policy frequently list Kydland and Prescott’s time inconsistency argument as the only reason for policy rules, and then they try to shoot that down or say it is outweighed by arguments in favor of discretion.  This is the gist of Narayana Kocherlakota’s recent argument for pure discretion.

But there are a host of reasons why a monetary policy based more on rules and less on discretion is desirable, and time inconsistency is only one. I listed these seven in a Harry Johnson Lecture that I gave back when Fed policy was more rules-based:


This list still applies today and it does not even include a key technical reason (call it number (8)) that I still stress to my Ph.D. students: The Lucas econometric policy evaluation critique implies that in a forward-looking world policy rules are needed simply to evaluate monetary policy

Understandably, John Taylor is an unconditional fan of his namesake rule. Interestingly Yellen says that the Fed shouldn´t “be chained to any rule whatsoever”. Why? Because monetary policy requires “sound judgment”? And rules won´t provide that?

Maybe that´s a problem associated with “instrument rules” like Taylor-type rules, which give out the “desired” setting for the interest rate instrument (the FF target rate in the case of the US). What if the central bank, instead of an “instrument rule” adopted a “target rule”?  For concreteness, let´s assume the Fed had adopted (maybe implicitly) a NGDP level target as it´s rule for monetary policy.

The charts compare and contrast the interest rate “policy rule” and the NGDP level target rule (where the “target (trend) level” is the “Great Moderation” (1987-05) trend). In this comparison, the actual setting of the Federal Funds (FF) rate is “right or wrong” depending on, not if it agrees with the setting “suggested” by the instrument rule, but if it is the rate that keeps NGDP close to the target path; and in case there is a deviation from the path, if the (re)setting drives NGDP back to the target.

For the “instrument rule”, I use the Mankiw version of the Taylor rule. The Mankiw version is simpler because it doesn´t require the estimation of an output gap and doesn´t state an inflation target rate (which the Fed didn´t have any way until January 2012).

The first chart shows John Taylor´s chart from his original 1993 paper. Note that it is qualitative (even if not exactly quantitative) similar to the “policy rule” obtained with the Mankiw rule.

During this period (1987 – 1992) monetary policy was “quite good”, in the sense of keeping NGDP close to the “target path”. Actually, when the Fed reduced the FF rate at the time of the stock market crash, it turned monetary policy a bit too expansionary, given NGDP went a bit above trend.

John Taylor_Rules_1

The next period covers 1993 – 1997. This is the core period of the “Great Moderation”. At the end of 1992, the FF rate had been reduced to 3%, a level which was maintained throughout 1993. According to the “policy rule” this was “too low”. With respect to the “target rule”, the FF rate was “just right”.

John Taylor_Rules_2

All through those years, NGDP remained very close to the “target path”, although the FF rate at times differed significantly from the “policy rule”.

The next period, 1998 – 2003.II is pretty damaging to the “policy rule” advocates. Taylor likes to say that the 2002 – 2005 period was one of “rates too low for too long” (having responsibility for the crash that came later).

What the chart tells us, however, is very different. The FF rate was too low in 1998 – 99. At this time, the Fed reacted to the Russia crisis (and the LTCM affair). Monetary policy loosened up at the same time that the economy was being buffeted by a positive productivity shock.

The monetary tightening that followed was a bit too strong because NGDP dropped below trend. The downward adjustment of the FF rate was correct in the sense that it stopped NGDP from falling lower, and by mid-2002 it began to recover. I wonder how much more grief the economy would have been subjected to if the “policy rule” had been followed.

John Taylor_Rules_3

The 2003.III – 2005 period is the second half of Taylor´s “too low for too long”. In the FOMC meeting of August 2003, the Fed adopted “forward guidance” (FG) (first it was “rates will remain low for a considerable period” followed by “will be patient to reduce accommodation, and finally “rates will rise at a measured pace”).  The fact is that FG helped push NGDP back to trend. Maybe the “pace was too measured”, but the fact is that by the time he handed the Fed to Bernanke, NGDP was square back on trend.

John Taylor_Rules_4

If the “policy rule” had been closely adhered to, the “Great Recession” would likely have happened sooner!

And now (“the end is near…”) we come to see how the Fed botched monetary policy (likely due to Bernanke´s preferred inflation targeting monetary policy regime).

The FF rate remained at the high level it had reached at the end of the “measured pace story”. At the end of 2006, aggregate demand (NGDP) began to deviate, at first slowly, below the trend level. The FF rate remained put (notice that although too high, the “rule rate” changed direction). The FOMC was not comfortable with the “elevated” price of oil and kept hammering on the risks of inflation expectations becoming un-anchored (see the late 2007-08 FOMC transcripts).

John Taylor_Rules_5

Despite the reduction in the FF rate, monetary policy was being tightened! And the “Great Recession” was invited in! Maybe there would have been a “Second Great Depression” if the “policy rate” had been followed closely.

Moral of the story. Yellen and the Fed do not have “infinite degrees of freedom”, hidden under the umbrella of “sound judgment”. They would do well to set a “target rule”.

PS Japan just improved on its 2% IT rule:

Japanese Prime Minister Shinzo Abe will announce a plan on Thursday to raise gross domestic product by around 22 percent to 600 trillion Japanese yen ($5 trillion) as he refocuses on the economy after the passage of controversial security bills that eroded his popularity.



The Verboten Topic? Central Bank Monetizing Of Debt Works? QE: The Rodney Dangerfield Of Macroeconomic Policies

A Benjamin Cole post

The central bank strategy of buying bonds, usually government issue, is known as “quantitative easing.” As practiced, QE appears stimulative, while paying off bondholders with cash, and essentially eliminating national debt. Nowhere has QE—in Europe, Japan, or the United States—resulted in much inflation. But one must scour the Internet in search of a favorable word on behalf of QE.

Oddly Enough

If you burrow deeply enough, you can find a paper written in September 2006 by right-wing iconic scholar John Taylor, who gushed about the positive results of QE, then undertaken by the Bank of Japan to flog some life into their deflation-slow growth economy.

“In the last three years, the Japanese economy has improved greatly compared to the decade-long period of near zero economic growth and deflation that began in the early 1990s. Once again Japanese economic growth is contributing to world economic growth as the expansion in Japan begins to set records for its durability.

What has been responsible for this recovery? The key to the recovery, in my view, has been the quantitative easing of monetary policy….”

Unfortunately, the Bank of Japan backed away from QE, and Japan went right back to the economic freezer. Evidently, the topic of QE thereafter became politicized.

Last Time

Taylor’s soliloquy to the triumph of QE might be the last time any U.S. economist said something nice about central bank monetizing, or paying off, of national debt to stimulate growth. From what I can gather, it is not PC in right-wing circles to like QE, as it is damned as either inert or hyperinflationary or maybe immoral, or in left-wing circles, who want piles of social welfare spending instead.

Moreover, there is a tangle of competing explanations why QE may or may not work, with a favorite dismissal in right-wing circles (since QE did not result in hyperinflation) that “QE is just a swap of bonds for reserves.”

Of course, this dismissal ignores the fact the Treasury bond-owners who sold into QE received cash, and also bank reserves swelled by an amount equivalent to the amount of QE. That is because when the Fed buys bonds, it does so only from the 22 primary dealers. The 22 primary dealers get reserves equal to Fed bond purchases, placed into their commercial bank accounts.


In academia there is little discussion that QE might stimulate consumption directly. That is, bond-sellers can place an immediate claim on goods and services, once they have sold their bonds. Before QE, a bond-seller would have to sell, say, a $100,000 Treasury bond to another private-sector buyer, and that buyer would have to give up $100,000 in cool cash. No new Jaguar in the garage for the bond-buyer. But, post-QE, the seller instead sells to the Fed, no one in the private sector gives up anything.

There is, post QE, $4 trillion in digital and paper cash out in the economy that can place immediate claim on goods, services or assets.

Of course, the Fed website talks obliquely about portfolio rebalancing, that is people who sell bonds move into other assets, pushing up prices. A rally in stock and property prices gets the economy going too. And interest rates (ceteris paribus) fall, and that is good too. But the direct consumption angle is not mentioned.

I also wonder about the positive effects of paying off the national debt with cash.  This topic is evidently verboten, and never discussed. But debt reduction it is going on in Japan, and without inflationary impact.

For decades, U.S. doomsayers have screamed about mounting national debt, and grandchildren in debt bondage to Chinese or Japanese overlords, or Wall Street rentier-barons. I do not like mounting national debt, btw.

But the Fed can print up money, pay off the national debt, and spur the economy. Inflation does nothing, at least so far.

What is it that economists don’t like about QE?

PS Rodney Dangerfield?  An American comedian, and very American at that.  Sadly, since passed away. “I tell you, I get no respect, no respect at all,” was his signature line. I liked his joke, told in the crime-ridden 1980s, “I tell you I get no respect. I go down to the grocers, and some guy holds me up with knife. It still has peanut-butter on it. No respect at all.” And QE gets no respect.

Bernanke takes on John Taylor and his (namesake) rule

I think Bernanke is still “taking it easy” in his blogging. I hope he´s “warming up” to what really matters, i.e. explaining why the Fed bungled in 2008!

Bashing the Taylor-rule is easy, even if, like me, you´ve never been a central banker. I did that in a number of posts (two examples, here and here).

In the following paragrah, BB disappoints, and indicates that the bad things that happened after 2008 were not the fault of the Fed. In fact, according to him, the Fed came out ahead of the pack!

As John points out, the US recovery has been disappointing. But attributing that to Fed policy is a stretch. The financial crisis of 2007-2009 was the worst at least since the Depression, and it left deep scars on the economy. The recovery faced other headwinds, such as tight fiscal policy from 2010 on and the resurgence of financial problems in Europe. Compared to other industrial countries, the US has enjoyed a relatively strong recovery from the Great Recession.

Monetary Policy Creates Financial Instability?

A Benjamin Cole post

Paul Krugman may be persona non grata in my house, but I must begrudgingly admit when the NYT blogger makes a good point:

“Let me also add that if it’s really that easy for monetary errors to endanger financial stability—if a deviation from perfection so small that it leaves no mark on the inflation rate is nonetheless enough to produce the second-worst financial crisis in history—this is an overwhelming argument for draconian bank regulation. Modest monetary mistakes will happen, so if you believe that these mistakes caused the global financial crisis you must surely believe that we need to do whatever it takes to make the system less fragile. Strange to say, however, I don’t seem to be hearing that from (John) Taylor or anyone else in that camp.”—Paul Krugman.

Krugman plays a little fast and loose here, and also ignores University of Chicago scholar John Cochrane, who has in fact called for major reforms, such as bank lending 100% backed by equity. No more 30-to-one leverage.

And inflation did sag after 2008, indicating monetary policy was too tight, as Market Monetarists have said. There was a “mark on the inflation rate,” such as Western economies sinking into deflation. I noticed that mark.

Still, Krugman has a point. We keep hearing monetary policy is too loose, and have heard that for 30 years. Yet the developed world is in deflation or close, led by Japan. Then we had a global financial collapse.

So, the record suggests the inflation-hysterics have it exactly backwards. If monetary policy has threatened financial stability, it has been because it has been too tight. We are in ZLB now—that is not a sign of decades of easy money.

Krugman has a point about banks, too. How is it in the U.S. we have such a feeble financial system? Why has the right-wing no interest in measures that would create strong banks? Being “against Dodd-Frank” is not a policy. If Dodd-Frank is no good, then embrace John Cochrane, or please devise a policy that would make for strong banks.

And, as I always say, print more money.

Because, not printing more money will have unintended and unforeseeable but catastrophic consequences on financial stability. Well, you can take out the word not, but the insanity level remains unchanged.

Is The Manhattan Institute Digging a Hole for the GOP?

A Benjamin Cole post

From David Glasner’s excellent blog, Uneasy Money, we learn that Stanford scholar John Taylor recently lectured the NY-based Manhattan Institute on the virtues of stable money, and that he will be followed this year by James Grant, the perennial doomster and gold fetishist. Grant will get $50k “Hayek Prize” for the chat, as did Taylor.

Grant, who has accurately predicted six out of the last zero U.S. hyperinflationary holocausts, will likely lecture the Manhattan Institute on the splendid 1921 recession, in which prices and wages tumbled, setting up a near-instant recovery, so that by 1923 everything was better than ever. The Fed existed, but did nothing, and that is the lesson, says Grant.

The GOP-right-wing today has so tightly embraced deflation, gold and Fed-bashing that nearly erased from history is that the Nixonians and Reaganauts wanted looser money (as I have documented in this space), and that Reagan’s Treasury Secretary Don Regan went so far as to propose putting the Fed under wing at the Treasury where it would report to him, and not then-Chairman Paul Volcker, inflation-fighter.

Thus, this modern-day GOP devotion to gold and salubrious deflationary recessions is historically recent—but is it mere posturing? We can hope.

2016: A GOP Sweep?

Pending is 2016, and the potential of another GOP sweep in Washington, D.C., ala 2000, when the GOP captured the House, Senate, and White House, and owned the Supreme Court too.

The last thing gimlet-eyed GOP operatives (assuming some are left) want after they get power in 2016 is a 2008 replay, when the Fed tightened, the economy collapsed, and the American public was so disenchanted they voted in an unknown, pretty-talking, skinny black man with a Islamic surname to be U.S. President. That is very disenchanted.

But with each of these tight-money-love-ins such as the Manhattan Institute pow-wows, and with each lifetime pledge of fidelity to gold that GOP candidates chisel into granite on the campaign trail, the harder it will be to gun the money presses after 2016.


Of course, maybe there is no problem. I am thinking like a human with some shreds of honor left, not a pol. After all, the GOP endlessly rhapsodizes about fiscal rectitude, but changes the mantra to “deficits don’t matter” whenever they control the federal purse.

Still, going forward, nothing but QE will probably work (see Japan) and that is rather obviously “printing money.” And big-time QE is rather obviously a long, long way from genuflecting to gold on the White House lawn, while James Grant looks prayerfully skywards.

So, I suspect the GOP will have to pass some sort of tax cuts (however minimal), a few regulatory changes, and then say that because structural impediments have been removed, the time has come to “gear America up.” That’s not a bad catchphrase, btw. “Gear America Up.” I hope the GOP is reading.

And then the GOP will print lots of money. I mean, boatloads of the stuff, like going over Niagara Falls in a record wet year. And indeed, I hope they do. I do not think the U.S. economy is inflation-prone. See Japan.

2016 could be a very good year.

PS. The Donks are no better than the GOP, and maybe worse.

PPS. Manhattan Institute: For $50,000 I will take the first Greyhound bus to NYC, and deliver the best speech ever made for tight money, lower taxes, radically diminished regulations and ______________. You can fill in the blank.