The Taylor Rule
Professor Taylor made one huge, simplifying assumption, that the neutral real Fed funds rate is a constant 2%.
Paul McCulley April 2010
The “considerable period” pre-commitment to 1% Fed funds had worked its magic, inducing animal-spirited risk- taking on both Wall Street and Main Street, and it was time, as I put it, for the Fed to end “happy hour prices” for liquidity:
The workhorse model for contemplating the destination was (and is to this day!) the Taylor Rule, primarily because Professor Taylor made one huge, simplifying assumption, that the neutral real Fed funds rate is a constant 2%.
With that assumption, plus assumptions for the Fed’s implicit inflation target and the Fed’s estimate of the full-employment GDP potential (alternatively, the NAIRU), it is easy to calculate where the Fed putatively should, according to Taylor, peg the nominal Fed funds rate. Indeed, Bloomberg now has a plug-and-play version of the Taylor Rule, where anybody can pretend to be a FOMC member.
And most conveniently, if you assume that inflation is at target and unemployment is at the NAIRU, all the “active” terms in the Taylor Rule drop out, and the neutral nominal Fed funds rate is simply the 2% neutral real Fed funds rate assumption plus the at-target inflation rate, which Taylor assumed – and the Fed preached both then and now – to also be 2%.
Thus, in an equilibrium Taylor world, the neutral nominal Fed funds rate is 4%, which is why, in my view, the consensus view in April 2004 held that the looming tightening cycle would take the Fed funds rate at least that high (and presumably, higher if and when inflation rose above target and/or the unemployment rate overshot the NAIRU to the downside, implying the need for “restrictive” monetary policy). John Taylor’s insights were and are very powerful.
And, indeed, his Rule is elegant. But it is also hostage to his assumption that the neutral real Fed funds rate is a constant 2%. I didn’t buy it in 2004 and don’t buy it today. In fact, I had voiced this view prior to that April 2004 first evening with you, notably in my August 2003 monthly2 (ironically just as the Fed evoked the “considerable period” regime).
My thesis was simple: The neutral real, after-tax Fed funds rate should be zero!
A year later, the evidence is in: Depression 2.0 has indeed been avoided. No, I haven’t yet bought that second home. In fact, I actually sold my only one, at a good level, as I was no longer using it, preferring to live in a little rental house on the water where I have my 32-foot fishing boat, named the Moral Hazard, and my 18-foot electric Duffy boat, named the Minsky Moment. Yes, I am sorta non-normal.
Roger E. Alcaly about
Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis
by John B. Taylor
NYRB Volume 57, Number 5 March 25, 2010
By any measure, the crisis was a consequence of extraordinarily reckless behavior—by banks and other financial institutions, by governments and their financial regulators, and by consumers—behavior that continued even in the face of a widely shared sense that serious trouble was brewing
The failure of central bankers and regulators to rein in leverage — the practice of borrowing as much as thirty or more times one's equity capital to increase investment potential —and excessive risk-taking owes much to complacency that had developed over the preceding twenty to twenty-five years.
Taylor's first public criticism was made two years after leaving that position in a paper presented to the annual August gathering of central bankers and monetary economists in Jackson Hole, Wyoming
Taylor argues that if the Fed had started raising interest rates in 2002, shortly after the end of the recession that followed the bursting of the technology stock bubble, the housing market would not have grown as wildly as it did. He bases his argument on his own "Taylor rule,"
Raising interest rates so slowly and steadily promoted excessive risk-taking, and should have concerned Greenspan, according to his stated views. The Fed's policies thus seem especially peculiar. They helped to create a false sense of security and stability that enticed financial institutions and investors to leverage their investments enormously, borrowing sums that dwarfed the capital they committed.
Last summer, I wrote a piece, "Lessons Learned from the Greenspan Era," for the Jackson Hole monetary conference
John B. Taylor, Wall Street Journal, July 13, 2006
The Fed and the Crisis: A Reply to Ben Bernanke
In his recent speech, the Fed chairman denied that too-low interest rates were responsible.
Does this mean we're headed for a new boom-bust cycle?
John B. Taylor WSJ JANUARY 10, 2010
John Taylor has a message for economists who say Ben S. Bernanke is ignoring a benchmark guide
for interest rates: They’re wrong.
Taylor should know: He wrote the rule.
Bloomberg July 24 2009
Economists from Goldman Sachs Group Inc., Macroeconomic Advisers LLC, Deutsche Bank Securities Inc. and even the San Francisco Federal Reserve Bank argue the Taylor Rule, a pointer for finding the correct level for interest rates, suggests the Fed should be doing a lot more to stimulate the economy.
Exploding debt threatens America
John Taylor, Financial Times May 26 2009
The deficit in 2019 is expected by the CBO to be $1,200bn (€859bn, £754bn). Income tax revenues are expected to be about $2,000bn that year, so a permanent 60 per cent across-the-board tax increase would be required to balance the budget. Clearly this will not and should not happen. So how else can debt service payments be brought down as a share of GDP?
Inflation will do it. But how much?
To bring the debt-to-GDP ratio down to the same level as at the end of 2008 would take a doubling of prices.
And 100 per cent inflation would, of course, mean a 100 per cent depreciation of the dollar. Americans would have to pay $2.80 for a euro; the Japanese could buy a dollar for Y50; and gold would be $2,000 per ounce.
This is not a forecast, because policy can change; rather it is an indication of how much systemic risk the government is now creating.
The rule brilliantly argued for by Milton Friedman in the 1960s was a money supply rule.
But would a monetary rule make sense in the spontaneous and generally innovative economies of, say, the US and the UK?
It is a good question.
Edmund Phelps, Financial Times, 25/4 2006
The Economist:
The current Fed chairman, Alan Greenspan, will retire shortly after his term as a governor expires at the end of January 2006. Who will replace him? One plausible candidate is John Taylor, the Treasury's point man for international affairs. He may not be the favourite to take charge but, according to many of his peers, the Fed long since submitted to “Taylor's rule”. This rule, which Mr Taylor first expounded in 1993, tries to capture the method behind the Fed’s interest-rate moves. Though it enjoys a great deal of discretion, America’s central bank, Mr Taylor argued, is systematic, not capricious, in responding to the rhythms of the economy.
Before 2007, independent central banks would have had no problem presenting credible exit strategies.
They would have pointed to their inflation target, and how they would use their medium-term inflation forecast or some other analytical framework to ensure that the price level would remain on a stable trajectory.
Wolfgang Münchau, FT July 26 2009
Ben Bernanke was elegant, concise, and yet he missed the point.
Last week, in his testimony to congress, the chairman of the Federal Reserve presented his “exit strategy” – a toolkit of policies to prevent an increase in inflation once the economy starts to recover.
The policies are the best modern central banking has to offer.
That is simply not the case any longer.
There are two big problems that need to be considered. One is the commercial banking system.
If the European Central Bank, for example, decided to exit tomorrow by raising interest rates, the likely consequence would be a banking meltdown.
A credible monetary exit strategy, in Europe at least, would read like a suicide note.
The other problem, which is more troublesome for the US than the eurozone, is fiscal policy. As James Hamilton, professor of economics at the University of California, San Diego, pointed out in a recent analysis,
http://www.econbrowser.com/archives/2009/07/looking_for_an_1.html
the direction of US debt, combined with the intermingling of monetary and fiscal policy, is inconsistent with the goal of long-term price stability.
Should there ever be a funding crisis, it is not clear how the Fed could easily raise interest rates under such circumstances without causing a political and economic bloodbath.
the ECB’s recent extraordinary €442bn ($630bn, £380bn) injection of one-year liquidity at an interest rate of 1 per cent. This is a win-win game for the banks, especially since they were able to post collateral consisting of less than perfect securities, to put it mildly – those with a rating of BBB- or higher.
Riksbanken har inklusive dagens SEK-auktion med fast ränta lånat ut 303 miljarder kronor
och 17,8 miljarder dollar.
Omräknat till dagens valutakurs har Riksbanken totalt lånat ut 500 miljarder kronor
Riksbanken 2009-07-13
Did inflation targeting fail?
Central banks have mostly escaped blame for the crisis.
How can it have gone so wrong? Also about The Taylor Rule
Martin Wolf, Financial Times, May 5 2009
Just over five years ago, Ben Bernanke, now chairman of the Federal Reserve,
gave a speech on the “Great Moderation”
– the declining volatility of inflation and output over the previous two decades.
In this he emphasised the beneficial role of improved monetary policy.
Central bankers felt proud of themselves.
Pride went before a fall. Today, they are struggling with the deepest recession since the 1930s, a banking system on government life-support and the danger of deflation.
How can it have gone so wrong?
This is no small matter. Over almost three decades, policymakers and academics became ever more confident that they had found, in inflation targeting, the holy grail of fiat (or man-made) money.
Frederic Mishkin of Columbia University, a former governor of the Federal Reserve and strong proponent of inflation targeting, argued, in a book published in 2007,
Monetary Policy Strategy (Massachusetts Institute of Technology, 2007)
that inflation targeting is an “information-inclusive strategy for the conduct of monetary policy”.
In other words, inflation targeting allows for all relevant variables – exchange rates, stock prices, housing prices and long-term bond prices – via their impact on activity and prospective inflation.
Now that we are living with the implosion of the financial system, this view is no longer plausible.
No less discredited is the related view, also advanced by the Fed, that it is better to deal with the aftermath of asset price bubbles than prick them in advance.
John Taylor of Stanford University, a former official in the Bush administration, argues that the Fed lost its way by keeping interest rates too low in the early 2000s and so ignoring his eponymous Taylor rule,
which relates interest rates to inflation and output.
Getting Off Track (Hoover Institution, 2009)
This caused the housing boom and the subsequent destructive bust (see charts).
This unforeseen crisis is surely a disaster for monetary policy.
Most of us – I was one – thought we had at last found the holy grail.
Now we know it was a mirage. This may be the last chance for fiat money.
Homeowners - the root of all evil?
Skuldfrågan/ Who is responsible?
Caroline Baum questions the accuracy, timeliness, and, ultimately, the usefulness of the Federal Reserve’s main gauge of inflation pressure in the system – the “output gap” – in today’s column at Bloomberg.
timiacono.com/ April 12, 2010
As in the 1970s, it seems the central bank would be quite surprised to see any substantive inflation develop today with U.S. unemployment high and factories chugging along at a full ten percentage points below the normal level of utilization.
Read about Stagflation here
Of course, over the last ten years, they’ve been quite surprised by a lot of things, not the least of which was all the trouble they caused by keeping rates too low for too long six or eight years ago.
Oh yeah, that’s right. The Fed still thinks thatlow rates had nothing to do with inflating the asset bubbles that led to multiple financial market meltdowns in recent years…
Chasing the Neutral Rate Down:
Financial Conditions, Monetary Policy, and the Taylor Rule
Paul McCulley and Ramin Toloui, February 2008
Central bankers and financial market participants like to refer to monetary policy as being in one of three states: neutral, accommodative, or restrictive. They also like to describe inflation as being at target (or in the “comfort zone” as Fed Chairman Bernanke puts it), above target, or below target. And finally, they like to describe unemployment as at its full employment potential level,1 above it, or below it. When inflation is at target, full employment prevails, and monetary policy is neutral…we have the nirvana of equilibrium!
John Taylor – a Stanford economics professor who also served several times as a U.S. government official3 – proposed in the early 1990s a pre-specified rule for setting the overnight policy rate based upon the deviation of inflation from its target level (inflation gap) and of actual GDP from its full-employment potential level (output gap).4 When inflation is above target, the central bank should increase the real short-term interest rate; when growth is below potential, the central bank should cut the real short-term interest rate. When a mix of factors prevails, the policy rate should reflect that, too. Taylor went on to illustrate that this rule provided a good template for understanding how the Fed actually did move interest rates, as well as a critical guide to how the Fed should move interest rates to maintain a stable economic trajectory.
Last summer, I wrote a piece, "Lessons Learned from the Greenspan Era," for the Jackson Hole monetary conference
John B. Taylor, Wall Street Journal, July 13, 2006
Since the beginning of Mr. Bernanke's term, the Fed has responded by raising the funds rate by 75 basis points -- to 5.25% from 4.5%, which is the neutral rate according to the St. Louis Fed's version of the "Taylor rule."
Some have argued that the lesson learned from this recent volatility experience is that the Fed should set a specific numerical target for inflation. I disagree; recent experience indicates setting such a target could increase volatility again.
Mr. Taylor, undersecretary of Treasury for international affairs 2001-2005, is a senior fellow at the Hoover Institution and the Mary and Robert Raymond professor of economics at Stanford.
My most certain idea is that real interest rates in the United States will have to be kept low, that the old Taylor rule is out
About bonds that are protected against inflation (TIPS/realräntepapper)
Bill Gross Investment Outlook November 2004