While members of the Trump admin were shopping around the shortlist of potential nominees I offered this criticism of Taylor:
Yesterday, in my usual routine of watching Bloomberg in the morning, there was a discussion of the possibility of Taylor for the top job at the Fed, and one of visuals was a graph of the FF rate compared to the output of the Taylor rule. According to the rule, the FF rate should currently be in the area of 3.25%, which seems problematic and would need to be explained.
It isn’t a particularly detailed objection, and David Glasner does a much better job of delving into the intricacies of why a Taylor nomination to the BoG in any capacity is somewhat problematic.
Let’s be very specific. The Fed, for better or for worse – I think for worse — has made a strategic decision to set a 2% inflation target. Taylor does not say whether he supports the 2% target; his criticism is that the Fed is not setting the instrument – the Fed Funds rate – that it uses to hit the 2% target in accordance with the Taylor rule. He regards the failure to set the Fed Funds rate in accordance with the Taylor rule as a departure from a rules-based policy. But the Fed has continually undershot its 2% inflation target for the past three [now almost six] years. So the question naturally arises: if the Fed had raised the Fed Funds rate to the level prescribed by the Taylor rule, would the Fed have succeeded in hitting its inflation target? If Taylor thinks that a higher Fed Funds rate than has prevailed since 2012 would have led to higher inflation than we experienced, then there is something very wrong with the Taylor rule, because, under the Taylor rule, the Fed Funds rate is positively related to the difference between the actual inflation rate and the target rate. If a Fed Funds rate higher than the rate set for the past three years would have led, as the Taylor rule implies, to lower inflation than we experienced, following the Taylor rule would have meant disregarding the Fed’s own inflation target. How is that consistent with a rules-based policy?
This is such an obvious point – and I am hardly the only one to have made it – that Taylor’s continuing failure to respond to it is simply inexcusable.
It isn’t that I wish to do Taylor’s job for him, and at that I undoubtedly would do very poorly. But in trying understand why the formulation of the Taylor rule results in a value for the FF rate today that appears to be insane, I think a good place to start is from clues from Taylor’s reasoning as summarized by Glasner in the same post:
I found several things in Taylor’s talk notable. First, and again to his credit, Taylor does, on occasion, acknowledge the possibility that other interpretations of events from his own are possible. Thus, in arguing that the good macroeconomic performance (“the Great Moderation”) from about 1985 to 2003, was the result of the widespread adoption of “rules-based” monetary policy, and that the subsequent financial crisis and deep recession were the results of the FOMC’s having shifted, after the 2001 recession, from that rules-based policy to a discretionary policy, by keeping interest rates too low for too long, Taylor did at least recognize the possibility that the reason that the path of interest rates after 2003 departed from the path that, he claims, had been followed during the Great Moderation was that the economy was entering a period of inherently greater instability in the early 2000s than in the previous two decades because of external conditions unrelated to actions taken by the Fed.
But despite acknowledging the possibility of another view, Taylor offers not a single argument against it. He merely reiterates his own unsupported opinion that the policy post-2003 became less rule-based than it had been from 1985 to 2003. However, later in his talk in a different context, Taylor does return to the argument that the Fed’s policy after 2003 was not fundamentally different from its policy before 2003. Here Taylor is assuming that Bernanke is acknowledging that there was a shift in from the rules-based monetary policy of 1985 to 2003, but that the post-2003 monetary policy, though not rule-based as in the way that it had been in 1985 to 2003, was rule-based in a different sense. I don’t believe that Bernanke would accept that there was a fundamental change in the nature of monetary policy after 2003, but that is not really my concern here.
It appears that Taylor’s base argument for rules based interest rate policy is based on two assumptions: 1) too low for too long caused the Great Recession, 2) following the Taylor rule would have prevented the Great recession.
Point number one is obviously false. Too low for too long could not have possibly caused the Great recession because if the level of the FF rate reflects a truly accommodative policy stance that is sustained, the problem to be dealt with would not be a recession from the nominal point of view. That claim is absurd in the way of being absurd on its face or absurdly short cut to completely miss the required element of too high too fast that the Taylor rule would not preclude.
I believe that point number two is not valid as following the Taylor Rule during the disputed time frame would have produced short nominal rates even lower after 2003 than they otherwise were, due to the tighter stance of policy producing a fall in the Wickcellian rate and a fall in inflation. During the gap in time between when a fall in inflation would occur and the time the Fed would have perceived such a fall, policy would naturally contract further than might be intended, while the Taylor rule setting dictates that rely on backward looking data would have locked the Fed into raising rates when a common sense view of economic conditions would dictate lowering them. In effect, this could have pulled contractionary policy from the future to possibly cause some version of the Great Recession earlier.
I am unsure why a policy rule based on backward looking data that, as argued, produces a consistently tighter policy would be regarded as producing consistently higher nominal rates, or any sort of stability. To David Glasner’s point, however, John Taylor himself needs to respond.
An additional and important point of the argument involves whether there was a change in the conduct of policy after 2003. Aside from Taylor’s argument that the Fed deviated from whichever rule it had been following in 2003 or 2004, I would argue that there has been a fundamental change in the conduct of policy at least since 2008 when positive IoER was adopted and then again in 2015 when the reverse repo facility was implemented. In light of these recent policy innovations, I would question the relevance of the Taylor Rule and wonder whether the present argument has been rendered moot. Though I suppose the obvious irrelevance of arguing Taylor’s formula in the presence of these policy innovations should be taken for granted at our own peril.