Thursday, July 5, 2012

The Taylor Rule and Unconventional Monetary Policy

Aaron Steelman has an "Interview with John B. Taylor" in the First Quarter 2012 issue of Region Focus, published by the Richmond Federal Reserve. The interview touches on a number of topics, but here, I'll focus on the "Taylor rule" and monetary policy. The questions that follow are my own phrasing: the answers are from the interview. (For the record, I've known John Taylor on a professional level for many years and have considerable respect for his work, but the fact that we share a last name is pure coincidence!)

What is the "Taylor rule" for monetary policy?

"The rule is quite simple. It says that the federal funds rate should be 1.5 times the inflation rate plus .5 times the GDP gap plus one. The reason that the response of the fed funds rate to inflation is greater than one is that you want to get the real interest rate to go up to take some of the inflation pressure out of the system. To some extent, it just has to be greater than one — we really don’t know the number precisely. One and a half is what I originally chose because I thought it was a reasonably good benchmark."

How closely has the Fed followed the "Taylor rule"?

"The biggest period where the deviations are apparent is the 1970s. ...  I also think there were significant deviations from the rule from 2003 to 2005, when basically there were rate cuts greater than I think any reasonable interpretation of the rule would suggest. So I think the period when the rule was followed fairly closely was roughly from the 1980s through 2003. The way I think about it is that the Fed’s actions have been largely consistent with the rule without using it explicitly.  ... In the late 1990s Chairman Greenspan told me that it explained about 80 percent of what they were doing during his tenure, but that doesn’t mean that he was looking at it explicitly."

What are the dangers of the nonconventional monetary policies that the Fed has used since 2008?

"During the worst of the 2008 panic, the Fed also provided funds that increased the balance sheet and if it had stuck to the exit policies that it pursued following 9/11 [when the Fed first increased and then reduced reserves], those reserves would have been reduced pretty quickly. But instead the Fed moved after the panic into interventions in the mortgage market and the medium-term Treasury market. ... [I]n the early part of 2009, Don Kohn [then vice-chairman of the Federal Reserve] was on a panel with me at a conference; I argued that while the Fed can talk about these temporary interventions during the panic, I would worry that if the recovery is slow, it will continue to do these sorts of things — not because there is a liquidity problem, but just because the economy is still sluggish. Kohn said, no we won’t do that. But that, in fact, was what the Fed did.

"So now we have a situation where there are massive interventions that are not conventional monetary policy and we need to get away from that. However, I’m not sure the Fed will get away from such policies, because now people are writing papers, including academic papers, which say the Fed can and should do these things: It can have its role in terms of setting the interest rate and it also can use its balance sheet to supposedly stimulate growth. The reason it can do that, people argue, is that the Fed now pays interest on reserves and thus it can ignore the supply and demand for money or reserves when setting the interest rate. I think that is not a good approach. It is very unpredictable and it will inherently raise questions about the independence of the Fed. So I would like the Fed to go back to a world where the interest rate is determined by the supply and demand of reserves. That would prevent this extra instrument from playing such a big role."

"The other thing that happened during this episode was that the interest rate got to the zero lower bound. That generated this idea that something else had to be done, that the balance sheet had to increase a lot. That is not the implication. The implication is that when the interest rate is at the zero lower bound, you should make sure money growth doesn’t fall. Whatever aggregate you look at, you need to make sure it doesn’t decline. That is much different than massive quantitative easing."