Evan Soltas
Mar 31, 2012

Unruly

Taylor's comments on monetary policy

There's an op-ed in The Wall Street Journal by economist John B. Taylor which strikes me as flawed.

"[W]e have plenty of evidence that rules-based monetary policies work and unpredictable discretionary policies don't," Taylor writes in the opening of the piece. Readers know I'm a big advocate for rules-based policy. But even I understand the importance of "bounded discretion" on the part of the central bank.

The most recent data for inflation and real output growth simply do not represent the sum total of all the information a central bank should consult, even if it is pursuing a targeting regime. Why? Because data gets revised, often substantially, and thus there is a "free lunch" in diversification. Even if we lived in a world where data as first reported was always right, other indicators can lead significantly and show warning signs before they come up in inflation or real output. Holding to a strict Taylor rule, after all, would have recommended several hundred basis points higher of a nominal federal funds rate well into 2008, until -- of course -- the financial crisis arrived. It'd be foolish to look at Bernanke's rate cuts in the earlier part of that year as a policy error.

Taylor thinks that the Fed's divergences from his Taylor rule explain the boom and bust of the real estate market, the credit crisis, the recession. I don't buy it.

It is simply not a plausible explanation: the deviations Taylor's talking about are around 1 or 2 percent and last for 3 years. There are plenty of examples when, with similar deviations lasting for the same amount of time, we don't end up in catastrophic recession as we have.  This is especially true if you look at different measures of inflation or of the output gap/capacity utilization/unemployment parameter, and the deviations are even smaller. NGDP didn't even return to trend fully after the 2001 recession.

Taylor also seems to be very confused about the monetary base. Somehow, he still hasn't got the message that inflation isn't going to come roaring back. Second, he says that the Fed hasn't some up with a strategy to rein it back in -- oh yeah, except for those constant reminders from the Fed that they're testing reverse repurchase agreements and the term deposit facility, and adding new primary dealer banks, etc. Taylor doesn't even seem to know it happened:

"This large expansion of bank money creates risks. If it is not undone, then the bank money will eventually pour out into the economy, causing inflation. If it is undone too quickly, banks may find it hard to adjust and pull back on loans."

I don't even understand the last sentence. These are excess reserves, not required reserves -- if the Fed reduced the amount of excess reserves, it would not reduce the money multiplier or compel banks to reduce their loan portfolios. Banks would have to make an independent decision to increase their Tier 1 capital ratios.

Taylor's understanding of the money market also strikes me as faulty:
"The combination of the prolonged zero interest rate and the bloated supply of bank money is potentially lethal. The Fed has effectively replaced the entire interbank money market and large segments of other markets with itself— i.e., the Fed determines the interest rate by declaring what it will pay on bank deposits at the Fed without regard for the supply and demand for money. By replacing large decentralized market with centralized control by a few government officials, the Fed is distorting incentives and interfering with price discovery with unintended consequences throughout the economy."

Remember, the Fed doesn't directly set the federal funds rate (it does do this for the discount rate). It targets the rate by buying and selling Treasury securities in the open market. And bank use of the discount window is almost zero again, after the rise in 2008 panic. Although the Fed has increased the monetary base to accomodate financial stress, the interbank money market has not been subject to some sort of government takeover.

"History shows that reform of the Federal Reserve Act is also needed to incentivize rules-based policy and prevent a return to excessive discretion. The Sound Dollar Act of 2012, a subject of hearings at the Joint Economic Committee this week, has a number of useful provisions. It removes the confusing dual mandate of "maximum employment" and "stable prices," which was put into the Federal Reserve Act during the interventionist wave of the 1970s. Instead it gives the Federal Reserve a single goal of "long-run price stability"...Giving all Federal Reserve district bank presidents—not only the New York Fed president—voting rights at every Federal Open Market Committee meeting, as does the Sound Dollar Act, would ensure that the entire Federal Reserve system is involved in designing and implementing the strategy."

The recession should have taught us all about how monetary policy should work: single mandates and flexible inflation targets only work when the central bank is properly empowered to create countercyclical inflation. Otherwise, a central bank that only targets inflation will grow far too defensive about inflation during recessions, as i've shown here. Also, there's a reason why we don't give all the FRBs voting power -- it's because they are tiny, all but irrelevant to the financial system, and run by community bankers who really don't know monetary policy.