Russ Roberts

John Taylor on Monetary Policy

EconTalk Episode with John Taylor
Hosted by Russ Roberts
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John Taylor of Stanford University talks about the Taylor Rule, his description of what the Fed ought to do and what it sometimes actually does, to keep inflation in check and the economy on a steady path. He argues that when the Fed has deviated from the Rule in recent years, the economy has performed poorly. Taylor also assesses the chances for a monetary or financial disaster and the Fed's recent expanded role in intervening in financial markets.

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0:36Intro. What should an educated person know understand what the Federal Reserve (Fed) is actually doing and trying to do? Main mission: keep the purchasing power of the dollar stable, prevent inflation, make sure we don't have a Great Depression again or high inflation as in the 1970s, mainly by keeping inflation low. Set up in 1914. Keep price level stable and avoid catastrophe like the Great Depression. Newspaper business sections would seem to think the job of the Fed is to steer the economy, stimulate it but not too much. Goal of price stability is consistent with keeping the economy stable. Can see that historically, macroeconomic models or just common sense. Late 1960s, early 1970s, inflation got into double digits, Fed would put on the brakes, boom and bust. Roughly 5 recessions, one every three or four years. Look at years started in the early 1980s, Volker followed by Greenspan, lower and steadier inflation rate. Had a huge reduction in the volatility of GDP; since 1982 only 2 recessions in a span of 25 years, and both very mild. Newspaper says you can either have price stability or growth. Very short term. Need long term perspective. Short term seems to have this trade-off, but it's a false tradeoff.
5:44To keep inflation down you have to keep the growth of the money supply down, but the way the Fed talks about its policy is through interest rate changes. Average person has the following story in mind: When the economy is slowing, the Fed needs to cut interest rates to stimulate the economy, and that in turn should stimulate monetary expansion, encouraging more borrowing, which in turn should raise prices. What is right way to think about what the Fed says in talking about interest rates? If you want to control inflation, control the money supply, more money causes higher prices. That is a fundamental aspect of monetary theory. But measuring money has become more difficult because of all the different ways people can pay for things, AMTs, credit cards, savings. What has happened is the use of the interest rate rather than money to control inflation. Now when they meet they debate what the Federal Funds rate should be. [Recorded Aug. 4, 2008.] Federal Funds rate is the rate that banks charge each other when they borrow overnight. Currently 2%, average; market rate, banks can charge anything they want. Fed affects it not by setting it directly but by supplying more or less funds to the market. If they withdraw funds from the market it makes money tighter and raises the Federal Funds rate. Same idea as if you were trying to affect the price of corn: supply more corn drives the price of corn down. What's the Fed doing? It's got to buy something. They could in fact buy ketchup. But what they do buy is Treasury Bills. If they want to raise the rate from 2% to 2.25%, they sell T-Bills and extract money from the economy. They watch the rate, not trying to pinpoint it exactly but try to keep it roughly around their target.
12:04At a time when they are injecting money into the economy and cutting the Federal Funds rate rate, why isn't that inflationary? Why won't that lead to a conflict between the stable price level and the healthy economy? Can be inflationary if overdone. Question is: how much? Benchmarks. Does require judgment. What they want to do is lower interest rates if inflation seems to be falling; if inflation starts to rise they should be raising interest rates, putting money out of the system. Want an even keel of price stability. Taylor Rule; distinction between what the Fed should do and what it actually does. What is the Taylor Rule? Both a guide and a description, both normative and positive. In the 1980s when Fed was moving away from money to interest rates as a guideline. Researchers were trying to build on the work of Milton Friedman, who emphasized transparency, policy rule for the money supply. Economists wanted to try to replace that rule with a guideline for the interest rate, normative, what the Fed "should" do. Taylor Rule: Fed should look at inflation and also state of the economy, GDP. If inflation rises by say 1 percentage point, Rule says the Fed should increase the interest rate by 1.5 percentage points. Important that the change should be larger than the change in the interest rate to get enough of a response by the system to bring inflation rate down. If GDP starts to fall, say by 1 percentage point from its growth page, Rule entails cutting the interest rate by ½ a percentage point. There the coefficient is .5, arrived at by trying different rules out within the model. And we had some natural experiments in history. Simulation within models, came up with Rule in the late 1980s, early 1990s. Soon after publishing that work, 1992, Federal Reserve policy turned out to be very closely described by that Rule; that it, it was a positive description, what actually was done. Throughout most of the 1990s till recently, closely describes Fed, though sometimes off. If you go back to the bad old days of the late 1960s and early 1970s, the Fed could not be described by this simple policy rule, and economy was doing poorly. Same story holds for many other countries. If they follow the Rule things are pretty good and if they don't follow the Rule things are pretty awful.
22:00One response: 25 years is a small drop in the bucket, maybe just random correlations. Is it more than just a coincidence? Nothing lasts forever, financial system or technology could change. Discussions frequently happen as to whether the Fed should engage in different policies. Happens sometimes. Looking back at 2000-2004, Fed had a rate lower than predicted by the Rule; now we have a crisis, which again suggests that going off the Rule was not a good idea. Emerging market countries, worried about exchange rates, Central Banks are getting off the Rule, maybe because exchange rates are becoming more of a factor. Glass half-full aspect: it's working. Benchmark, not meant to be mechanical, need to have people making judgments. But when you've seen deviations it's led to events we'd rather not have. 1987, stock market crash; 1998, Fed went under what was predicted by the Rule, ultimately required tightening the monetary policy; recession, though after revisions it was not a recession because there weren't two consecutive quarters of GDP growth decline. Labor markets acted like they were in a recession, similar to current situation: GDP growing but jobs declining. Surprising how long it took the labor market to look like it was a healthy economy. We've had 25, even 50 good years though the 1960s and 1970s weren't great. Is that true relative to the 19th century when we didn't have a Federal Reserve? And: how ought we structure the Fed and maybe chastise the Chair down the road if the Rule is not followed? Look back, Great Depression was terrible performance, double-digit, 25% unemployment rate, Friedman and Anna Schwartz, Fed didn't keep money growth up, can blame the Fed. In last 25 years we've avoided those kinds of catastrophes, under the leadership of very skilled people, Volker, Greenspan, really tremendous. How can you prevent people from doing the wrong thing fo political reasons? True of all kinds of public policy, have vested interests, earmarks, corrupt officials. We can rely on our democracy to get the best people whether it's tax policy or monetary policy, recordings like this podcast so people can debate these policies. Giving some independence to the leadership so they are not tied to political policy; though that can go the wrong way.
31:57Artfulness of the job; might we not have been better off if we had implemented Milton Friedman's steady rule, say, mechanically run by a computer? Didn't go very far politically. Disadvantages of deviating. Deviation of 2002-2003 period; if they deviate again it will get them back on track. Friedman podcast: they talk about it but they really follow a steady money growth rule. What he's saying here: Take the Taylor Rule, increase interest rates when inflation rises, so you are really pulling back on the money supply, like keeping the money growth rate constant. Good sign of robustness of the Taylor Rule is that it has features like a fixed money growth rule. With a fixed money growth rule if inflation picks up then real money balances decline, amount of money compared to prices, purchasing power of money, which automatically causes interest rates to rise. Magnitudes might not be the same as with Taylor Rule, but similar results. But a fixed money growth rule is not how Central Banks think about it.
35:46Risks currently in place in our economic system. Barro, disasters, still low but increased risk now. Economy grew last quarter, though not as much as we'd like; job growth is negative but relatively small compared to past downturns. But people wave around frightening scenarios. Under the surface, some unusual happenings that would make anyone worry. Look at financial system, at 3-month bank lending to each other, unusually high. Suggests banks are worried about lending to each other, unusual risk factor. Due to the fact that there are unusual securities out there, mortgage obligations that people don't know how to assess their value. If housing prices continue to fall, those securities will seem even more suspect. But how will that spread to the rest of the economy? So far, though economy is weak, it could be worse. Three players in the financial market situation: Fed and Treasury have both acted unusually. Bear Stearns, Freddie Mac, and Fannie Mae. Couldn't let them fail, Fed orchestrated rescue of Bear Stearns, forcing it into a salvage operation; about to bail out Freddie Mac and Fannie Mae. If Bear Stearns made poor decisions, shouldn't it just go out of business, creditors should have paid the full price? What was Fed worried about? Hard to assess from the outside, spillover. Creditors would get stuck with the collateral of Bear Stearns's loans. Some of those creditors were mutual funds, money market mutual funds; they would be obligated to sell that, could put money market mutual funds at risk. Moral hazard, encouraging people to take risk. Have to find a way to clarify what will happen in the future. What about a hedge fund? Crucial for the Fed, Treasury, and Government to clarify. Public officials have not yet articulated it. Guidelines: when will an intervention like that take place. Reporting system, so when you do intervene there is a follow-up report. People who made these bad decisions have to have better accountability in the financial systems.
44:56Head of Bear Stearns lost about $100 million, pretty high price, pretty accountable. Subprime, people bundle a lot of junk together and sold it to someone who was expected to sell it to someone else. A smart person, any person should realize that prices could come down. A lot of people who took the risks are accountable, losing their houses, money. Some of the interventions have reduced accountability. People who lent money to Bear Stearns were bailed out. They made unwise decisions but they are being left alone. Danger here is that by trying to prevent the spillovers you reduce the effective risk people are holding which results in more risk. Financial sector does have spillovers. Liquidity in the U.S. system. Good in general that institutions lend to each other but not good if you don't look too closely. Value of all the financial instruments is tremendous but the complexity creates more risk. Transparency; rating agencies did a terrible job. Possible to limit spillover to people who were not involved in taking the risks. High leverage ratios, market place should do a good job to limit that risk without bailouts, but with bailouts it encourages people to take more risks, run into the spillover problem all over again. And people blame it on the markets. Step back, look at the whole deal, can't help but be optimistic about the future. Low risk, whole world has capitalism and markets spreading, billions of people coming from poverty to the middle class. What's happened in China could happen in Africa. Will look back on current experience as a learning experience.

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COMMENTS (16 to date)
Ron Hardin writes:

The Fed can't buy and sell ketchup, actually, for an important reason : it heavily affects the activity of the economy in a particular area.

The most evenhanded intervention is handing money to investors in general, or taking it away from investors in general.

You want an evenhanded intervention so that you can measure the effect with minimal ripples superimposed.

You could say it as : it makes possible a leading indicator of inflation that's orthogonal to the ripples of intervention, so that the Fed does not blind itself by intervening.

John writes:

Two thirds through the podcast Russ makes the point that the current economy is expanding slowly while loosing jobs. Can someone quickly comment on whether this is due entirely to productivity gains...is there some other factor that might be involved?

Schepp writes:

Russ and Dr. Taylor or others

I have a hard time keeping track of how the money supply stays balanced. I always thought that the Fed issued all the treasury bonds that Congress and the Prez authorized. So I understand there can be small difference in T-Bills sold to buyers and the amount needed to cover our debt, but how does the Fed lower interest rates when the congress is cranking out debt?

I would appreciate any help on the question.

John,

My surmize is that productivity is increasing, businesses are less likely to take a chance on hiring new people and loading up current most productive employees. I also think there may be a lag between the comodity price increases and the realization that human capital may have a competitive advantage over comodities.

Another interesting thing that I heard on NPR was that consumer electronics were doing well. Folks are loading up with entertainment that does not require gasoline expenditures.

Charlie writes:

I have heard John Taylor argue that monetary policy was too loose in the 2000-2004 period (JT gave those dates as well as 2002-2003), but inflation in the following period has been moderate:

Annually CPI & core CPI
2000 3.4 2.4
2001 2.8 2.6
2002 1.6 2.4
2003 2.3 1.4
2004 2.7 1.8
2005 3.0 2.2
2006 3.8 2.5
2007 2.5 2.3

Inflation is moderate over this period, even with an 18 month monetary policy lag core CPI is between 2 - 3% and CPI below 4%. Is core CPI a bad measure, that is, when there is an oil price increase shock should the fed raise rates? Even if the rates were slightly lower than optimal, it seems like a stretch to blame the low rates on the situation we are in. Slightly higher rates would moderate inflation expectations over the coming period, long term interest rates that home owners faced may have been the same. And even if the interest rates were a little higher, what is the evidence that we would have seen a substantial reduction in the housing bubble? And if so, how would that reduction affect the real economy in that period? Would unemployment have been much higher? I would like to hear John Taylor's argument spelled out in a more detailed manner. Is there a model?

John writes:

Schepp,
Didn’t large numbers of people go to the movies during the Great Depression? ... Something about being able to postpone reality.
I guess I’m not convinced that high consumer electronics sales isn’t just our version.

All,
At one point in the podcast Russ makes the point that the Fed has moved away from dealing rhetorically with the ‘money supply’ to now dealing rhetorically with ‘interest rates’...with the implication that ‘money supply’ has become too unwieldy and amorphous a term, while ‘interest rates’ still gets at the same issue (money supply) and is still accessible to everyone.

I’d be interested to understand what kinds of things have slipped into the ‘money supply’ that have made the term less well defined. Could 2nd mortgage credit leveraging have increased the money supply under everyone’s noses? Is this all just a combination of shadowy money supply inflation and a downshifting economy? Are we certain that productivity is increasing?

Gary Rogers writes:

Excellent podcast! I learned about the Taylor rule about six months ago and was immediately impressed by its simplicity and after listening to this podcast am also impressed by its transparency. This is the kind of macro-economic guidelines that economists must provide our politicians to prevent them from destroying the economy as politicians tend to do if left unchecked.

As for the reason for all the concern about the economy, I can only speak to my own pessimism that starts with a 10 trillion dollar federal debt and grows when I look at the underlying cause of current problems. We have a country that has reached its credit limit and is now having trouble paying for its expensive houses and cars and is running up credit card debt just to stay afloat. It bothers me that the first reaction from the government is to borrow another 180 billion dollars to stimulate the economy so consumers continue spending like they have in the past. We are not going to solve our current situation with more economic stimulation! It is going to take time for delevereging and economic policies need to recognize and encourage corrective action. In other words, let the markets work. I would love to see a new rule or an addition to the Taylor rule that looks at consumer savings and debt and adjusts policy accordingly.

Unit writes:

It's hard for me to believe that such a simple rule would be better than just doing nothing. Of course, I don't know much of anything, but it reminds me of when I get sick: I take the medicine and get better, but I always second-guess myself and wonder "what if I didn't take anything? Would I have gotten better anyways?".

JB writes:

When the papers report that the Fed cut the rate from 2.25 to 2.00 is the Fed selling t-bills into the market or buying them back?

In either case when I look at number of 28-day auctions the Fed has had this year I wonder how these infusions of money into the economy do not have either inflationary effects or change the interest rates.

Can someone help me out?

I will go back and listen to the other podcasts about the Fed as I am one of those folks who read the business pages that thought the Fed actually raised/lowered the federal funds rate.

Russ Roberts writes:

JB,

The Fed's action do cause inflation or deflation depending on the size of the infusion/reduction relative to the growth in output. Taylor's point is that the Fed should strive for a low, stable rate of inflation.

Jon writes:

Russ, I appreciated you asking about what horrible effects would ensue if the bailout didn't happen. MSM articles whisper words like "counterparty risk" and are very non-specific, as if we're supposed to understand that once someone holding more than 10 bad mortgages defaults, the whole financial system will freeze up.

It seems like a large default could be quite painful and have wide-ranging consequences, but how often would you have to go through it? Once a generation? Once every 50 years? If LTCM had been allowed to fail, would people who run financial institutions really have leveraged themselves to 15 or 30 times capital in 2006? And even if they wanted to, would large banks really lend to them, knowing what had happened to those left in the lurch when LTCM failed? Would one single failure be so catastrophic that it must be avoided at all costs? It seems like this notion is mostly speculation and has little academic work to back it up.

I'd love for someone to prove that wrong if anyone knows historical US or foreign examples where this (a financial system freezeup caused by a bankruptcy) happened.

Also, regarding Taylor's suggestion of standardized bailout criteria - wouldn't that create a moral hazard of its own? Let's say that the Fed has declared that anyone holding more than 5% of the total mortgages in the country gets bailed out if their capital ratio falls below x - surely banks that have 4% would be inclined to increase their mortgage holdings - even if all that was available was subprime... once you know the criteria for getting bailed out, won't your existing lenders force you to meet that?

Charlie writes:

I agree with Jon's first comment; I would like to have seen you grill JT or future economists more on the systemic risk questions. It's not because I don't think their is a lot to the arguments (lots of smart economists find them persuasive), but that it is very rarely fleshed out what we are basing this on, is it economic models, practical judgement or more closely risk aversion by central bankers?

muirgeo writes:

"And people blame it on the markets."


Well who should take the blame? The fed seemed to turn to every whim of the markets providing more and more easy credit. The bail out occurred because IMO the Fed and the markets are one and the same. These are the same guys in the same industries riding the revolving doors from profiteer to regulator.

Seared into my memory is Jim Kramer from CNBC's Mad Money screaming into the cameras at the Fed to lower rates and infuse more money.

There is no separation from the markets and the fed. Isn't that a problem? How do we create more of a wall between them. This was not a failure of too much regulation or too much oversight but quite the opposite.

And I am certainly not going to give the fed a pass on their decision with out great detail as to how and why they made it.

enronal writes:

"And people blame it on the markets."

The point is it's a delusion to think "if markets worked, economic growth would be smooth and uninterrupted now and forever. Since that's not the case, markets don't work." Markets are made up of people whose emotions at times lead to bad decisions. With or without markets, imperfect, emotional people would be making decisions. If you ask, "do markets work compared to alternatives forms of economic organization," the history of the last century or so provides a pretty definitive answer.

Russ Wood writes:

It continues to amaze me how free market advocates not only accept the Federal Reserve system but cheer its performance in the past two decades. Name one other good or service where we would willingly accept its price being set by a committee of 17 bureaucrats meeting in secret.
The Taylor rule removes the human factor and turns pricing over to the myriad market participants. The only way to get a better system would be to find one that has a more direct link to market prices than the Taylor rule, which relies on seriously flawed gubment stats like GDP and CPI. If only there was a commodity which had been used for price stability for a few thousand years; we wouldn't even need the bureaucrats at the Fed.

RG writes:

^ Gold perhaps? would it be safe to assume we wouldn't be in this mess if there was still a gold standard?

Ray G writes:

Just listened to this, 12Oct08. Very, very good listen given the timing.

I'd say prescient but it wasn't that hard to see, and it wasn't that long ago, but it's still an excellent listen considering all that has taken place in such a short time.

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