Festivus 2017 Airing of Grievances -- I Gotta a Lot of Problems with You, Taylor Rule
December 23rd is almost upon us. You know what that means. It’s time for me to work up my annual airing of grievances for Festivus 2017. Although I have myriad political-economic grievances for 2017, I am going to concentrate on only one in this annual Festivus epistle – the Taylor Rule. For decades, there has been a debate as to whether central bank monetary policies should be guided by some clearly-defined rule or should central banks be free to operate with discretion, i.e., by the seat of their collective pants. I come down on the side of a rule vs. discretion. But not on the side of the rule most often mentioned, the Taylor Rule.
In 1993, John Taylor, a Stanford University economics professor, published a research paper in which he purported to describe how the Federal Reserve had conducted monetary policy in terms of its movement of the federal funds interest rate from 1987 through 1992. Essentially what Taylor did was estimate a Fed reaction function to consumer goods/service price inflation above or below a perceived Fed inflation target and to real GDP growth above or below a perceived Fed real GDP target. In his 1993 research paper, Taylor suggested that his description of past Fed monetary policy decisions in terms of movement of the federal funds rate could be useful as a guideline as to how the Fed shouldoperate in the future. Although Taylor did not suggest in his 1993 research paper that the Fed should adhere rigidly to his estimated reaction function, subsequently he has implicitly criticized Fed policy for not hueing to his rule (see “A Monetary Policy for the Future”, April 16, 2015)
In its basic form, the Taylor reaction function is:
So, this formula states that for every 1% rise in inflation above its target, the Fed would raise the federal funds rate by 0.5% and similarly for every 1% increase in the output gap (actual real GDP as a percent of potential real GDP, the Fed would raise the federal funds rate by 0.5%. If actual inflation rate were equal to the Fed’s target inflation rate and if actual real GDP were equal to potential real GDP (i.e., the output gap were zero) then the nominal, or observed, federal funds rate would equal the unobservable real equilibrium federal funds rate, assumed by Taylor to be 2%, plus the inflation rate.
My grievances with the Taylor Rule arise out of the old saw, it’s not what you don’t know that will hurt you, but what you think you know but don’t. There are two elements in the Taylor Rule that are assumed to be known but are not, in fact known. The first of these elements is “r”, the equilibrium real federal funds rate. Just as the price of wheat variesover time because of changes in the supply and demand for wheat, so does the real equilibrium federal funds rate vary over time. Changes in fiscal policy, changes in business “animal spirits”, changes in the age distribution of the population, to name just a few factors, can change the equilibrium level of the real federal funds rate. If the actualequilibrium real federal funds rate has risen to 3% from the assumed level of 2% in the Taylor Rule, then the Fed would persistently be keeping the nominal federal funds rate too low for an extended period of time, which would result in persistently accelerating inflation rate. This was why Milton Friedman, may he rest in peace, argued against the Fed using an interest rate as its policy instrument. No one knows what is the equilibrium level of the nominal interest rate, much less the real interest rate, which would also require knowledge of what inflation expectations are. In some instances, a 3% federal funds rate might represent an accommodative monetary policy. In other instances it might represent a restrictive monetary policy. If the Fed persistently keeps the level of the federal funds rate low compared to its equilibrium level, an inflationary spiral will result. If the Fed persistently keeps the federal funds rate high compared to its equilibrium, a deflationary spiral will result.