Monday, January 11, 2010


Taylor Rules Bernanke

I actually don't know how I feel about the Taylor Rule. One economist (maybe Roger Garrison but I'm not sure) observed once that the so-called Taylor Rule was descriptive, not prescriptive; it simply codified a rule of thumb between price inflation and slack in output, in order to roughly explain the Fed's actual interest rate decisions over a certain period.

Anyway, von Pepe sends me this WSJ article in which John Taylor defends his Rule from Ben Bernanke's attack. Some excerpts:
Federal Reserve Board Chairman Ben Bernanke spent most of his speech to the American Economic Association on Jan. 3 responding to the critique that easy monetary policy during 2002-2005 contributed to the housing boom, to excessive risk taking, and thereby to the financial crisis.

...Mr. Bernanke focused most of his time on my research, especially on a well-known policy benchmark commonly known as the Taylor rule.

This rule calls for central banks to increase interest rates by a certain amount when price inflation rises and to decrease interest rates by a certain amount when the economy goes into a recession. My critique, which I presented at the annual Jackson Hole conference for central bankers in the summer of 2007, is based on the simple observation that the Fed's target for the federal-funds interest rate was well below what the Taylor rule would call for in 2002-2005. By this measure the interest rate was too low for too long, reducing borrowing costs and accelerating the housing boom. The deviation from the Taylor rule, which had characterized good monetary policy during the previous two decades, was the largest since the turbulent 1970s.

In his speech, Mr. Bernanke's main response to this critique was to propose alternatives to the standard Taylor ruleā€”and then to use the alternatives to rationalize the Fed's policy in 2002-2005.

In one alternative, which addresses what he describes as his "most significant concern regarding the use of the standard Taylor rule," he put the Fed's forecasts of future inflation into the Taylor rule rather than actual measured inflation. Because the Fed's inflation forecasts were lower than current inflation during this period, this alternative obviously gives a lower target interest rate and seems to justify the Fed's decisions at the time.

There are several problems with this procedure. First, the Fed's forecasts of inflation were too low. Inflation increased rather than decreased in 2002-2005. Second, as shown by economists Athanasios Orphanides and Volker Wieland, who previously served on the Federal Reserve Board staff, if one uses the average of private sector inflation forecasts rather than the Fed's forecasts, the interest rate would still have been judged as too low for too long.
I think the part I put in bold is pretty funny. Taylor doesn't come out and say it, but really Bernanke is saying that, "The problem with a fixed rule based on objective circumstances, is that I might want to do something else."

Right Bernanke, rules constraining government (and quasi-government) institutions are put there precisely to limit the discretion of "experts" so they can't wreck the economy, start wars, etc. I think the record of the 2000s speaks for itself.

I have my own version of the Chain Rule - it never yields a better answer, but I like it more.
Is Bernanke saying that the Taylor Rule is hopeless because it requires inflation forecasts which are inherently impossible to get right?

And what does that say about the possibility of the Fed ever using it's price control powers in a manner that doesn't put mile thick lead shields around the price signals of the market?
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"The problem with a fixed rule based on objective circumstances, is that I might want to do something else."
Isn't this, in 1 sentence, the script that most elites read from?
Interesting post! Of course, Bernanke is right. Only libertarians believe in following rules. Socialists think rules are nothing but ideology and only pragmatism, discretion by elites, will save us.

But this leaves me a little confused about Sumner's economics. It seems that the Feds have been setting policy by inflation forecasts as Sumner preaches. So where's Sumner's beef? His only complaint might be that the forecasts are wrong, but that's typical of all forecasting.
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"So where's Sumner's beef? His only complaint might be that the forecasts are wrong, but that's typical of all forecasting."

Sumner's beef is that he knows better!

If we are going to have a Fed I'd rather it follow a rule like the Taylor Rule, then leave it up to experimentation by the experts...after all wasn't it experimentation by the experts (FDR) that let the Great Depression go on for so long?
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