David R. Henderson  

What's Wrong with the Taylor Rule?

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Economists have long debated whether rules or discretion should govern monetary policy. But after inflation declined in the 1980s, the debate partly subsided as many began to favor what are called "feedback rules." With strict rules seen as too rigid and unconstrained discretion as too flexible, feedback rules allegedly provided the best of both worlds. And the premier feedback rule is the Taylor Rule. Indeed, many critics of the Federal Reserve, believing that it had exercised far too much discretion either prior to or in response to the financial crisis of 2007-2008, conclude that it should have adhered more closely to the Taylor Rule. Some have now gone so far as to propose legally binding the Fed to this kind of feedback rule. Yet a closer look at the Taylor Rule reveals that it is fundamentally flawed and could well make monetary policy worse.
This is the opening paragraph of "What's Wrong with the Taylor Rule?" by San Jose State University economics professor Jeffrey Rogers Hummel. It's one of the two Featured Articles for November's Econlib.

Here's one of my favorite paragraphs:

Although economists disagree about the magnitude, extent, and duration of the liquidity effect, the bottom line is that the initial impact of monetary policy on interest rates is self-reversing. Therefore, depending on inflationary expectations, low nominal interest rates can be a sign of either tight or easy money. This dilemma bedeviled monetary policy until the work of Milton Friedman and the Great Inflation of the 1970s brought widespread acceptance of the Fisher effect. Indeed, it was not until the Taylor Rule that central banks had an explicit model for adjusting their interest-rate target for this effect. That this rule took so long to develop should be a source of both embarrassment and epistemic humility for economic policy makers.

And here's what I regard as the most important paragraph of Jeff's critique:
But the deeper, more critical flaw in Taylor Rules is that the long-run, equilibrium real rate of interest--or what is alternatively called the natural or neutral rate--is also unobservable. Yet these rules make the astonishing assumption that their estimates are not only correct but also relatively fixed and unchanging over extended periods. In short, Taylor Rules virtually preclude any factor, other than central banks, from affecting the equilibrium real rate of interest. A standard rationale for this assumption is what is known as the Ramsay-Cass-Koopmans model. This model estimates the natural interest rate for a closed economy with a fixed number of infinitely-lived households, all identical. Each household has the same rate of time preference, the same declining marginal utility of consumption, and the same rate of population growth. This almost rules out any fluctuations in the natural rate that might arise from alterations in how individuals discount the future, from how consumption preferences may differ among individuals or alter over time for one individual, or from differences in the distribution of wealth.


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CATEGORIES: Monetary Policy




COMMENTS (17 to date)
david writes:

I had the impression that the natural rate is uniquely identified by full employment in the kinds of New Keynesian models that Jeff is describing

and whilst we may bicker about whether the output gap is really best approximated by unemployment, the output gap is nonetheless observable

of course you can discard this optimistic assumption and say that the natural rate may not be consistent with full employment. That is very attractive to Austrians! But then you also need to say what market failure is driving that divergence

Tom P writes:

Another big problem with Taylor Rules is that they are difficult to estimate with a regression, so we don't know what settings lead to good outcomes.

For example, the central bank could have a bias towards loosening for some time; that would cause interest rates to be temporarily depressed, but inflation to be temporarily high. We would then estimate a negative coefficient in a Taylor rule regression, when the true coefficient might well be positive.

This is where I came in...to the serious study of economics, back in the 1970s. Deciding that the stagflationary environment required some self-defense on my part, one of the first things I did was to re-read the little book that was the transcript of the Friedman-Heller debate at NYU in 1968.

Heller makes the claim, literally, that 'interest rates are the price of money', and Friedman corrects him. Since that day, I've never taken analysis of monetary policy that relies on 'interest rates' seriously.

And it continues to amaze me that most economists are still drawn to such analyses, as moths to flame.

Scott Sumner writes:

Good post--I completely agree.

David R. Henderson writes:

@Patrick R. Sullivan,
Thanks for the reference. I loved that debate, which I read when I was about 20. I had a very pleasant conversation with Heller on the phone in 1980. Sometime soon I’ll tell that story.
@Scott Sumner,
Thanks. BTW, he mentions you positively in part that I did not quote.

Andrew_FL writes:

@david-

of course you can discard this optimistic assumption and say that the natural rate may not be consistent with full employment. That is very attractive to Austrians! But then you also need to say what market failure is driving that divergence

I'm at a loss to understand this comment. I think I would say that the interest rate(s) consistent with an equivalence between investment and voluntary savings need not necessarily always coincide with only a frictional level of unemployment, but I don't see why you consider this a market failure in need of explaining. Beside which, there are in fact government policies which make it unlikely that purely frictional unemployment would coincide with the interest rate consistent with voluntary savings being equated to investment.

I observe smart people discussing something of great complexity. They say desired Monetary Policy provides money which is neither loose nor tight. Bad effects in either extreme will cause either unemployment or inflation.

To my surprise, they don't have a current definition of loose or tight. It seems they have to look back a few years to make up plausable stories about whether money was such in the past, but there is no reliable method to determine this in the present. There are different opinions about what makes a difference. Possibly there is the Taylor rule, but they don't know. Possibly case by case discretion is best, but this is an appeal to experience and judgement, somehow a rule of many parts with many interpretations and impossible to write down.

The entire aim is to increase employment to match some number which is supposed to be natural, but also unobservable in the present. Usually, more people per capita were employed in the past, and the goal is to get there again, although we don't know what happened to employ that percent in the past and don't know why they received the real output that they did. Employment is an aggregate statistic for a system of unimaginable complexity, an economy staffed by around 200 million people.

Money is the sole focus, but we know that government regulation, political interference, tax policy, and technical change have large and direct effects, again largely unknown.

The solution to the problem so far has been to create a federal monopoly on creating and managing money, enforced by an army of armed Treasury Agents. We do this despite the evidence that a market of relatively free entry, experiment, and competition beats all top-down, authoritarian organizations to solve problems and increase productivity.

Am I crazy to think that I am observing a convention of witch doctors throwing bones on a sophisticated ground of mathematical models?

Say I wanted to solve the problem of how many railcars should be built in the US each year, located where and of what type and cost. This is a vital problem each year in the US economy. A tight or loose supply of railcars produces inefficiency, waste, and possibly unemployment. It is valuable to estimate how many railcars are needed next year and in five years. Would the solution involve assigning a federal monopoly that task, for the good of the country? Would there be complicated theories about how railcar production might affect unemployment? How would one formulate a Railcar Taylor Rule, or any rule?

David R. Henderson writes:

@Andrew_M-Garland,
Very good comment. I don’t think, by the way, that Jeff Hummel would disagree with you. Check the last paragraph of his article, which I don’t quote here.

Shayne Cook writes:

From the last paragraph ...

"In short, Taylor Rules virtually preclude any factor, other than central banks, from affecting the equilibrium real rate of interest. A standard rationale for this assumption is what is known as the Ramsay-Cass-Koopmans model. This model estimates the natural interest rate for a closed economy with a fixed number of infinitely-lived households, all identical." [emphasis mine]

... following which, Professor Hummel highlights a few of the flaws in relying on this underlying assumption with regard to established/establishing monetary policy rules.

But one of the things that concerns me is that nearly all of the alternative recommendations for monetary policy - rule-based or discretionary - still rely on the "closed economy" assumption. Policy recommendations, formulaic or otherwise, that rely exclusively on U.S. economic metrics (NGDP, RGDP, UER, etc.) reflect that "closed economy" assumption.

The U.S. economy is not a closed economy, nor should it be. And the U.S. dollar is the primary global reserve currency, as well as the global preferred medium of exchange for many critical globally traded commodities, not the least of which is oil. There indeed are several small countries (Zimbabwe, for example) which have either defacto or dejure adopted the U.S. dollar as their recognized sovereign currency. Both to have a stable, reliable currency, and to rely on the U.S. Federal Reserve to keep it that way.

So the U.S. Federal Reserve is managing a global currency. It's first obligations, of course, must be to the U.S. economy, as stipulated in it's "dual mandate". But in doing so, it must consider the global impacts of it's policy measures - in context with its U.S. obligation.

Any alternative monetary policy rule, recommendation, or guidance that relies solely on U.S. economic measures - on the "closed economy" assumption - is silly, flawed and potentially very detrimental to the U.S. economy - as much so as Professor Hummel points regarding the "Taylor Rule".

(The "Taylor Rule" uses only U.S. economic metrics as its variables.)

Don Geddis writes:

@Shayne Cook: NGDPLT doesn't by any means assume that the US is a closed economy. It does, of course, run monetary policy for the benefit of US citizens. But it's perfectly compatible with the US dollar being a global currency, and with international flows of capital. (It just puts no weight on whether US monetary policy causes unemployment or inflation in Zimbabwe.)

@Andrew_M_Garland: Your concern sounds plausible, but I think you overstate the case. We can indeed get real-time information on the current state of monetary policy, e.g. by creating an NGDP futures market, or (less well) by looking at current TIPS spreads (or even just stock market reactions to monetary communications).

It is not important to exactly figure out the NAIRU; nor is it important that the NAIRU be stable. Shooting for an NGDPLT that is large enough to cause low (but positive) inflation, allows the economy to settle into minimum effective unemployment.

As to alternative frameworks for money: there are significant network effects to a single standard. So much so, that the "competitive money is illegal" is probably superfluous. There may be a feasible free banking structure, but many such advocates focus far too much on the "medium of exchange" aspect of money, when the monetary policy effects are all about the "medium of account". And just because you stop controlling monetary policy, doesn't mean that it doesn't happen. E.g. free banking money that happened to result in a gold standard would still respond to its implicit monetary policy, which would be worse for the macro economy than NGDPLT.

Andrew_FL writes:

@Don Geddis-As one such advocate of free banking, unsurprisingly I disagree with what you're saying here. But to be more specific:

You seem to assert that money is a natural monopoly, in as much as you believe a uniform unit of account is necessary and inevitable. I think this represents a fairly to understand the way free banks compete. Not, really, in terms of offering different standards, but competing in terms of the public's confidence.

Second, you suggest that free banking on a Gold Standard would be worse than NGDPLT. Personally I find it doubtful that Gold would necessarily prevail over all other possible reserve commodities, including the possibility of making use of a frozen or automatically managed monetary based for this purpose. But in any case, you're offering a false choice here: Either Free Banking or Nominal Income Targeting of some form. In point of fact, as George Selgin has pointed out, there is no reason why the two things can't be complementary. To think otherwise is a category error, conflating banking regimes with base money regimes.

Don Geddis writes:

@Andrew_FL: Yes, I suspect that network effects suggest that money is a natural monopoly. (I wouldn't describe it as "necessary and inevitable". Societies survive with barter, but there are great advantages to an economy having a uniform money standard.) And yes, I'm talking about the unit of account; competition in the medium of exchange is much less important to the economy.

Yes, gold was just meant to be an example; other choices for the base are easily possible too. And I completely agree with you that monetary policy still happens with free banking (whether intended or not). That was actually my point: "free banking" is not a response to "why not NGDPLT?" Just because you don't plan a monetary policy, doesn't mean that you don't experience one.

So I'm perfectly happy with you throwing away "free banking", as irrelevant to the question of what monetary policy leads to the best economic outcomes.

Andrew_FL writes:

@Don Geddis-Now hold on there a minute! I did not say that "monetary policy still happens" with free banking. What I said was that you can have a base money policy set by the government with freedom in banking. You don't have to do so.

With regard to a natural monopoly in the unit of account, I don't agree that it's more important to the economy as a whole.

And I emphatically do not "throw away free banking as irrelevant to the question of what monetary policy leads to the best outcomes" because it is not irrelevant at all. In point of fact, achieving NGDPLT is much easier under free banking than otherwise, because it allows one to do so by focusing on that which one has direct control over: the quantity of base money.

Don Geddis writes:

@Andrew_FL: There's obviously a lot we disagree about, but I'm not sure it matters. The OP was about a critique of the Taylor Rule(s). More generally, we can discuss a critique of inflation targeting. When considering alternative monetary policies, NGDPLT has been suggested.

You're now saying that free banking is relevant to this discussion of alternative monetary policies, because it makes "achieving NGDPLT much easier". That's an unexpected claim, and in any case appears to be a solution in search of a problem. The US Fed would have no difficulty achieving NGDPLT, if only it wanted to. All the (significant) debate is about what the Fed's goals should be. While now and then someone expresses a concern about concrete steppes, advocates of NGDPLT have very little concern about the "how" of implementing such a monetary policy. If free banking is proposed as a solution to the "how", that doesn't seem to be a very compelling argument, as it isn't much of a problem.

Andrew_FL writes:

@Don Geddis-"if only it wanted to"

Exactly. Under free banking, you scarcely have to worry whether the Fed wants to target NGDP at all, because in or to target NGDP under free banking, M adjusts automatically to changes in V. You just need a rule for the monetary base.

So it's easier in the sense that one can take all "wanting to" out of the equation.

Don Geddis writes:

@Andrew_FL: I still don't get it. In either case, we have a current economic structure with a central bank, currently following some monetary policy. We want to suggest that monetary policy follow NGDPLT instead. That's a political question, about getting society to agree to a new framework. How does offering "adopt free banking and also an NGDPLT rule for the monetary base" make for an easier political question than "require the Fed to follow NGDPLT from now on"?

It seems like, in either case, you need to convince the public to agree to NGDPLT. But you're suggesting that it would be somehow easier to say "and also adopt free banking at the same time". I don't see how adding an additional change makes anything easier.

Andrew_FL writes:

@Don Geddis-It's easier to get the Fed to implement a NGDPLT rule, if all they have to do to do so is set a rule for the monetary base.

The thing is, that I find your belief that the Fed can be induced to follow any rule a little bit naive. They might do so for a while, but more likely they'll abruptly abandon it when the political winds change. But a rule for the monetary base can be done by a computer.

This is not a matter of convincing "the public" of anything. "The public" has no idea what NGDPLT is, they never will know, and they aren't going to vote on it. It's a matter of getting the policy makers to actually follow a rule.

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