Intro. [Recording date: January 24, 2022.]
Russ Roberts: Today is January 24th, 2022, and my guest is John Taylor, the Mary and Robert Raymond Professor of Economics at Stanford University and the George B. Schultz Senior Fellow in Economics at Stanford University's Hoover Institution. This is John's sixth appearance on the program. He was last here in April of 2012, which seems like a different century, talking about Rules, Discretion, and First Principles.
Our topic for today is inflation.
I want to remind listeners that voting will close soon for your favorite episodes of 2021. So, please go to econtalk.org, where you'll find a link to the survey that will let you pick your favorite episodes of last year.
John, welcome back to EconTalk.
John Taylor: Good to be here. Thanks, Russ. Thanks for having me.
Russ Roberts: Well, for the first time in a long time, there's inflation in America, and elsewhere, and people are unnerved by this. And, many listeners have written to me asking for some primer or the basics of inflation. That's our goal today. And, I'm sure we'll get into some more complicated things along the way, but I want to start with just the simplest idea, which is actually quite complex and people typically I think have trouble with it, which is: 'What is inflation?' When we say inflation is 3% or we say inflation is a problem or we say inflation is rising, what does that mean?
John Taylor: That's a good question. It's a good place to begin. First of all, you have to think about a measure of prices. What economists do and statisticians do is they measure the average level of prices. Sometimes it's the average level of consumer prices--that gives you something called the consumer price index. It's an average. And, the average gives higher weight to items which people purchase more of and less weight for people purchase less. So, it's a comprehensive index, consumer price index.
Inflation is how much that changes over time. How much does it change month per month, year to year, over a long period of time?
And, so, it is meant to be comprehensive, as you mentioned. And, again, the consumer price index is consumer prices in the United States. The producer price index is producer prices. So, that's what we're referring to.
And, the concern that many people have paid attention to and mentioned recently is that these average prices are rising quite a bit. And, so, just for example, the consumer price index, if you measured over the last year from December 2021, it's around 7%. So, that's quite a large increase and it includes all sorts of stuff--gasoline, meat, food, rent, everything. It's not everything is going up, but a lot has gone up.
Russ Roberts: And, I think it's important to distinguish between a price, a single price going up. That's not inflation; it doesn't mean that there is inflation. It doesn't cause inflation. So, if you notice that for whatever reason, let's say there's a refinery issue in America and gasoline prices are rising, that doesn't mean there's inflation. It means one of the prices of the many, many things we buy has gone up, and it's very possible that other things have gone down.
In fact, they could have gone down more so that there's actually deflation, even though some prices might be rising. But, the key part of what you've just described is that there's a basket of stuff that the government measures the average price of that basket. And, they try to base that basket on what people spend money on. And, that basket is not the same for you as it is for me. It's not the same if you live in Palo Alto, California versus Biloxi, Mississippi. So, it's a crude measure of the overall impulse of prices to be rising over a period of time. And--when was it last close to 7%? Seven percent is pretty high relative to recently.
John Taylor: It's very high. It's been much lower than that. It has not been a concern.
Of course, if you go way back in time, it was even higher. In the 1970s, it was quite high. And, as each time it was high, there's evidence that in a broader basis, monetary policy was too aggressive in the sense of letting inflation rise. So, we can get back to that, Russ. But, I think if you look in the 1970s in the United States, inflation got over 7%, got up to double digits. And, what had to happen was the Fed [Federal Reserve Bank] had to undo that; and it was very painful. So, what we hope is the undoing is not so painful. We haven't gone into this, but ultimately, the broader-based movements that you're referring to are really very closely related to monetary policy.
Yes, you can have an increase in one item, two items, and decreases in others. In fact, in the Fed and other central banks, they think the best rate is 2%. Two is the target. If we had 2% inflation, it would be fine. In fact, for a long time, we had 2. That was good. And, you mentioned that inflation rose in the past, but frequently, it's just one price for[?] that price. But this is different now, at least in the United States. It's different. It's not just one price. Again, it's across the board. We haven't seen the Consumer Price Index. It's just that average you're referring to. So, it takes into account some--some prices are declining for sure. But, on average, the inflation rate is close to 7%. And, that's a concern because we don't want to have it that high forever. And, we can talk a little bit about the costs of inflation. Maybe it's not as costly as people think, but the Fed and others have a 2% target.
Russ Roberts: We're going to talk about the role of monetary policy. A standard explanation of inflation is it's caused by too many dollars chasing too few goods, is the way it's often described. That's not a bad starting point, at least the way I was educated, but we'll come back to that when we talk about the cause. But, I first want to talk about whether it's something we should worry about. Why is it a concern? Yes, the Fed has a target of 2%, but let's say it's a 7% year-in, year-out. Is that a bad thing? What's wrong with that?
John Taylor: Well, first of all, it's bad if it's not across the board and frequently we just talked about prices. And, so, prices are rising that much and wages are not rising, then it's really cutting into people's income quite a bit.
So, I think what you're asking about is what's so bad about a system which is 7%, and everybody--wages are increasing, prices are increasing. And, I think probably the number one problem with that is it really erodes the ability of monetary policy to work. It doesn't really work anymore. And, so, that's taking away a big part of stabilization in the economy. Fortunately, Russ, we've given up on that.
Russ Roberts: Let's back up for a sec, right? Let's say inflation 7% and it's year-in, year-out, and it's pretty steady. I would have thought--if you'd ask me, 'Why is it dangerous?' I would say, 'Well, because it might be 12 next year. And, if people don't prepare for that, their wages are going to not keep up and it's going to bite into their standard living and people can't plan for what the cost of things are going to be in the future.' And, it hurts businesses' effectiveness. But let's just say about the 7%.
Let's say it's 7% year-in, year-ut. It's not rising, the rate itself, the rate of inflation. Prices are rising, but at a constant rate, the rate itself isn't rising. It's stuck at 7%. And, now, there's a recession, right? There's a recession. And, normally, the Fed might respond to that. Talk about how and why if inflation is 7%, it limits its ability to do so. And, then you can talk about--we don't believe it anymore or whatever else you were going to add.
John Taylor: Well, the thing is if you have a 7% inflation, then interest rates will have to be 9%, 10%, because they need to be a little higher than the inflation rate to have their effect. And, so, a world where interest rates are averaged 7 or 8% is a different world. We had that world in the past and it wasn't pleasant--frequently because interest rates went up and interest rates went down. And, so, it caused a real problem with the allocation of resources. The interest rate is a very important variable in the economy. It affects how much people invest, how much people save. And, I think you're pointing to a very important issue. If the inflation rate is rising and falling and frequently, it's not just 7.
In fact, I'm looking at a history of inflation in the United States. It was never just 7. It was 7; it got higher and higher; then it got lower and lower. So, I think what's good about the 2--and maybe it should be one-and-a-half; we don't know for sure--what's good about the 2 is that it's reasonably close to zero. It's actually pretty much global. Many other countries think it's a good target, at this point. And, from an international perspective, it's also good to have a similar inflation rate in different countries. Because that way, the exchange rate is not always changing.
If you have a very high inflation rate and the rest of the world has low, then your currency is going to be depreciating. Yes, if it's a steady rate, who cares?--you could put it. But it's not a steady rate.
This is not rocket science. This is something which it's difficult to pursue. And, the 2% is a good target to have. If you go to 7, almost for sure central banks will want to reduce it back to some lower level. And, that's what they'll do. And, you can be sure that's what the Fed is thinking about now.
Russ Roberts: But, I think again, there is a question of why they would want to do that. And, I think in the back of monetary theorists like yourself, and people who advise and encourage the Fed to do certain things, there's a risk of hyperinflation--a time. And, again, it's not so much the--hyperinflation means a higher rate than, say, seven. A much higher rate can be 100%: prices could double every year.
And, again, I think the issue isn't so much whether they're doubling. It's whether they're doubling some years and tripling in others and going up 50% in others. And, what that starts to do is discourage the use of the economic system for exchanging goods. It encourages people to barter, because goods stay--keep their value--and money doesn't.
So, if you swap a chicken for $10 and in a few months or a few weeks or in some systems, a few days, the $10 doesn't buy a whole chicken anymore, you have an incentive to get rid of your money. And, after a while, you just start to insist on people giving you chickens. And then you're in a barter economy. And, all of a sudden, you're a lot poorer.
And, this is the world that has happened numerous times in world history. And, it is devastating to financial, material wellbeing and devastating, really, to civilization.
People start spending a huge amount of time trying to find people to swap stuff with, because they don't have the power of currency to exchange. They have to use goods and they have to find people who want the things they have--chickens if you're a chicken farmer or haircuts if you're a barber. And, that's just incredibly inefficient. So, although I make fun of efficiency occasionally on this program, as an economic goal, if you start to destroy the use of currency as a way for people to exchange goods, you get a lot poor.
John Taylor: That's for sure. Actually, this is not a new idea either, Russ. It's very important to point out. If you can see behind me, there's a California license plate. I don't know if you can see it.
Russ Roberts: I can see it. Yeah. For those watching on YouTube. Yeah.
John Taylor: If you're watching, yes. Those are Milton Friedman's license plates. He was out here for a while. And the M is money. V is velocity.
Russ Roberts: Explain what's on the license plate.
John Taylor: It says 'MV = PY'. That's money times velocity equals the price level times GDP [Gross Domestic Product, or income, represented by Y]. And, so, the equals sign is not the official signal of California. It's a piece of tape that Milton Friedman put onto the plate. And, occasionally, I understood from Milton is that the California highway patrol would take the equals sign down; but Milton would put it up the next day. So, it would still say money times velocity equals price times income. And, it's an old thing. It's called the quantity equation of money. It said, if you increase M--you can see it right there. If you increase money a lot and velocity doesn't change and output doesn't change and we're not going to make output change unfortunately, only thing that happens is inflation rises.
And your questions are what is so bad about inflation rising? And, one thing that's bad is people don't like it. People say, 'Hey, this is a terrible situation.' When we look in other countries, Zimbabwe, or look at the United States in the 1970s, people didn't like it.
And so, they threw the guys out, and there was all sorts of complaints. The Chairman of the Fed in the 1970s was Arthur Burns. He said, 'It wasn't me. Don't look at me. It's something else.' And, so, he told Nixon, who was the President of the United States at the time, to just have controls--to just have controls on wages and prices; and that's what Nixon did. Didn't work. And so, so Burns eventually left and was replaced and things got better. Sorry to go on and on so much.
Russ Roberts: Oh no, no, that's your job. Just so I want to say something about MV = PY. So, Y, you said GDP, and then another time you said income, another time you said output. They're all approximately the same thing. In economics, I tends to stand for the interest rate, the letter I, so economists needed a different letter for income because it starts with an I, so they used Y. So, that's why it's MV equals PY. And, I think it goes back--correct me if I'm wrong--to Irving Fisher and his book, The Theory of Interest, which might also include, if not, the other works of Irving's that have hydraulic systems to try to--a visual representation of the way that money percolates through the economy. [The hydraulics pics are from The Purchasing Power of Money, by Irving Fisher--Econlib Ed.]
And the idea, as you said, is that if V, the velocity at which money is moving through the economy, and Y don't [change--Econlib Ed.]--the output level, which is hard to change in the short run--increases in M just result in higher prices--higher levels of the price level. Which, if you continue to do that, leads to inflation--sustained, ongoing increases in the average level of prices in the economy.
Russ Roberts: Let's talk about causation and what causes inflation. There used to be a big debate in the profession of economics about what did cause inflation. Most of that seems to have been forgotten--where now, it's like we're starting over to some extent. When I was in graduate school, 'Inflation,' to quote, Milton Freeman, 'was everywhere and always a monetary phenomenon'.
There were other theories of inflation, such as, you could argue, corporate greed, which many people are doing on Twitter these days, or elsewhere on the floor of the Senate. That, because corporations want to make more money, they're raising prices. Of course, the problem with that theory is that was everyone wants to make more money. Why are they able to raise prices now and not other times? Did they juust get greedy today and not yesterday?
So, there are other theories including issues about the supply side and the demand side. But, you believe, I believe, that it's money. What do you think of those other theories? Anything to them?
John Taylor: Not much. They've been around for a long time. As you pointed out, they've come back into popularity now. But it's, in a sense, a replay. It used to be in the 1970s, 'Oh, it's just supply side, just have to have controls,' like Burns, who was the Chairman of the Fed, said at the time. And, now there's the supply constraints they're putting to the ships waiting to come into the Harbor, for example.
Russ Roberts: Yeah. Is that relevant?
John Taylor: No, it's not really relevant, because on top of this, you have this extraordinary, unusual monetary policy. Interest rates are very low compared to what they would normally be. And, we have other ways to measure this. We can get into it if you like. But, I think the idea that it's not money is a small minority, and there's always hope--there's always hope out there that it's something else. And, economics is tough. You teach it, you talk about it. It's easy to make up new stories. And, sure, 'Hey, it must be these supply constraints that's doing it.' But, when you look at the difference, you look at money growth, if you look at the interest rates, if you look at what the Fed is doing, it is very unusual.
We've never seen it this bad before. You're referring to periods--in fact, it's even worse than the 1970s. And, we don't know if it'll continue. There's lots of talk at the Fed about making some adjustments, but right now it's way off.
And, I think you can look at other theories, but what dominates this discussion is monetary policy. And through history you can see: Why did inflation pick up in the 1970s? It wasn't just for supply. People were just, 'Oh, it's OPEC [Organization of Petroleum Exporting Countries],' or something like that. No. And, as soon as the Fed changed and Paul Volcker was the person [new Fed Chairman], it changed and inflation came down again. And, then the Fed had targets. And, it has been very low until very recently.
Russ Roberts: Well, let me say something about the 1970s, and then I want to come back to the supply constraints, the so-called global supply chain problems we've been having in the COVID era. In the 1970s, in the aftermath of the OPEC--the oil embargo--which 1973, approximately, people said, 'Oh, that's obviously the cause of the very high inflation in the second part of the 1970s.' The problem with that theory is that the OPEC theory explains why the price of oil is high. It doesn't explain why the price of everything is high. And they'd say, 'Well, but oil is used in other things.' That's true, but it's--a lot of things it's not used in at all.
And, those things, if--we understand that the things that use a lot of oil are very energy intensive would get more expensive in those time periods. But, if monetary policy was not expansionary, those other things could have gotten less expensive. And they didn't. And, it's easy to get confused by relative price changes, but we're talking about, when we talk about inflation, is the overall rise across the whole economy.
Russ Roberts: So, let's turn to the supply chain argument. I want to digress for a minute, maybe, because I know you teach Principles of Economics and have for a long time. To me, the most startling and challenging and jarring aspect of the COVID--almost two years now--is that prices didn't rise at the retail level.
We have all these shortages. We have things that would never have ever happened in the United States, in my lifetime--that is, empty shelves. Yes, we had empty gasoline pumps when we had price controls on gasoline in the 1970s, but the idea of going into a store and not being able to find meat, not being able to find toilet paper, is what we think of is what happens under communism. For that to happen under capitalism requires there to be something that is restraining prices from rising.
And, it could be law, sometimes--legislation. It could be there's anti-price gouging rules that keep that from high happening. Or it could be cultural: the businesss are uneasy raising prices during this kind of cultural challenge.
But, how do you think about that? Do you talk about that in your class? I used to teach all the time: Our prices cause markets to clear, and we don't have shortages in the United States unless there's legislation against prices rising. And, yet what we've had until the last few months and the last year is lots of shortages, prices not rising, and no inflation. What are your thoughts on that?
John Taylor: Well, I think the system--you know, the terrible hit, that's for sure. But, the system was working pretty well. Some prices were--some shelves were empty, so orders were up. Ships were lined up, couldn't get the stuff in. But, I think there are always constraints like that. There are always issues on the supply side.
What is very different now is monetary policy, and you can point to that. It began a year ago, a year and a half ago. I think the action that the Federal Reserve and other central banks took in March, April, May of 2020 was quite reasonable. But, then this continued all through in 2021, and inflation started to pick up.
There's other [?] besides MV equals PY, which you can see that and people were pointing out. But the Fed, I think, was concerned about the kind of things you're mentioning; and others were, too. They don't have the history. They don't look at it as much as I do, or you do, or the students taking Economics 1 do. And so, it has to be emphasized. But it seems to me, you always have the supply side. You could have a slow growth economy. You could have a fast growth economy. And that is largely due to other things besides monetary policy. It's tax policy, it's regulatory policy, it's the capitalist system versus democracy as the state of activity that the economy is in at that point in time. So, your monetary policy has to be attuned to that. And, right now, we think that the growth rate is around maybe 2.5%. I don't know.
Russ Roberts: Of the economy as a whole?
John Taylor: Yes, two-and-a-half real growth for the economy. Well, so will see. It might be higher. It might be lower, but there's not much debate about that. The issue is inflation and there's, again, more and more people are coming around to the idea--other people like me have been arguing for a while--they're coming around to the idea that this has to be taken care of and the Fed is the place to do it. There's going to be debate for sure, Russ, just as you indicated.
Russ Roberts: But, here's the puzzle for me. Well, I don't pay as much attention to the Fed quite as much as John Taylor does. I think that there are many people who don't. John is in a very small club that pays an immense amount of attention to the Fed, which is good, because you hold their feet to the fire occasionally and sometimes often. But, what did they do that was so different a year or so ago that was concerning to people who worry about inflation? What was the change in their policy that was so dramatic?
John Taylor: First of all, they held interest rates near zero when all the indicators of inflation was picking up, the economy was returning close to normal. Not exactly. So, all the things you'd normally have a higher interest rate were signaling raise the rate and the Fed didn't do that. There's reasons for that.
It's not just the Fed: the European Central Bank had a slightly negative rate. They haven't made the adjustments yet. They're debating that with the Bank of Japan. So, it's an international phenomenon; and we can talk about this, but central banks do react to each other and think about what's happening. But, ultimately, at this point, the Fed kept rates, and still keep the interest rates near zero. They haven't made the adjustments yet.
Russ Roberts: But, when you say interest rates--let's back up for a minute, and we probably talked about this on the program before, but since I don't remember it, I'm sure many listeners don't either.
There are different kinds of interest rates. The interest people, I think, think about the interest rates in their daily life that--you might have a mortgage that has an interest rate on it. You might have a bond that promises you a certain rate of return for you lending that money to a company or to a government. But, the Fed has particular interest rates that it adjusts that then affect other interest rates in the rest of the economy. So, talk about--when you say the Fed kept interest rates low, I assume you're talking about the rates that they directly control, not the ones they try to indirectly control. And, if so, explain.
John Taylor: Well, for the most part, the rate which the Fed has normally controlled--in the sense of their adjusting the supply of money to bring that rate into line--has been the Federal Funds Rate. It's the overnight rate that banks charge when they lend to each other. But, since the Fed can control the amount of liquidity--the amount of money in the economy--they can affect that rate. So, that's the primary rate that's near zero. When I say the rate is near as zero, I mean the short term rate. You can look it up, Federal Funds Rate. Look it up on any website, and you'll see it's like 0.1% or 0.15%. That's the rate I'm referring to. And, that rate does feed back into mortgage rates, longer term rates, rates you have to pay on for borrowing a car, the rates businesses have to pay.
And, so, if that rate is very low, that increases the amount of demand in the economy. And, that's what you're seeing now. Even though the supply has not increased very much--in fact, you could argue supply is declining. So, the Federal Reserve--and I think more people should know about the Fed. It's a very important entity. It's got a great deal of independence in the United States, and it's a very important phenomenon. We have monetary policy. We also have fiscal policy. That's the deficit. We're not talking about that so much. We're talking about monetary policy. And, for the most part, that's what the Fed does.
And, they do other things. They buy bonds. They sell bonds. That's sometimes called Quantitative Easing [QE], because they've increased the size of their so-called balance sheet quite a bit. It's another measure of policy. They've agreed to stop increasing it, but it's going to be very large in a couple months or so. So, there's other measures. But the thing that I'm focused on mainly now and central banks do for the most part is this shorter-term interest rate. And, that's that number that is near zero in the United States. And, if the Fed began to raise that as they have in the past--again, this is the most unusual discrepancy, most unusual divergence between what the interest rate is, the Federal Funds Rate, the overnight rate that banks charge each other. That rate is as low as it's ever been compared to what is the best determinants of that, which is inflation is very high and that has to be taken care of.
Russ Roberts: So, to make sure I understand, you're arguing that the Federal Reserve has kept that overnight rate low. Now, do they keep that low statutorily? Do they literally set that rate or do they intervene in the market to cause the rate to be at a particular level?
John Taylor: For the most part, they intervene in the market that causes that rate to be that. They buy and sell bonds and they provide the amount of so-called liquidity--is what economists call it--to make the rate low. So, they would supply less to make the rate higher. And, there's questions about how to do that, how fast to do that. They've been reluctant to do that, obviously, but again, they're as far off as I've ever seen it.
Russ Roberts: But, hasn't that been true now for a long, long time? I think there's always a temptation to--I mean, 7% is a big number and you mentioned before we started recording that the Producer Price Index rose 20% last year, which is suggestive of future consumer price increases that will exceed 7%. But hasn't the Fed been off the rails for 15 years and haven't interest rates been near zero? When I say interest rates, not necessarily the Federal Funds Rate, but overall interest rates for low-risk activity in the economy. Hasn't this been a much bigger, longer, older problem?
John Taylor: Well, it has been longer. I mentioned in the 1970s, it's a problem, but there's a period in 2004, 2005, 2006, where rate was also low compared to inflation, compared to the state of the economy. And, that ultimately meant the Fed had to react. And, so, they reacted and we had this terrible recession, 2007, 2008. And, so, that's some of the dangers of providing too much. It has to be offset. And, so, that was offset and we had a terrible recession. It wasn't good.
And, then as you mentioned, more recent periods, it took a while for the Fed to start raising rates, but they did. It started with Janet Yellen--she was the Chair--and then continued with Jay Powell [Jerome Powell]. And, then they gave up on it, but it still wasn't even close to the difference that we see now. The interest rate was a little low, the economy wasn't doing that well. There was all sorts of questions about how strong it was going to be in 2014, 2015, but they did start to raise rates in 2016, 2017, into 2018. And, it was only towards the end of 2019, they started to raise them. And, then now it's zero again. So, they go up and down, but there are two periods, three if you count the current one, where they were way off. One is the 1970s. Two is 2004 and 2005, and three is now.
Russ Roberts: Are you suggesting we're going to have a recession soon in the United States?
John Taylor: No, not if the Fed does what they need to do. And, there's other--always--recessions that are possible, but I'm not predicting a recession. I'm predicting that what the Fed needs to do is make an adjustment. There's nothing wrong with interest rates that are 2%, 3%, rather than zero. I'm talking about the Federal Funds Rate, to be sure.
Russ Roberts: How high did they get during Janet Yellen's time?
John Taylor: Well, Janet just began to raise rates. So, probably it was still low, but Jay Powell took over and he took him up to 2.5%, 3%.
Russ Roberts: And, now it's down to 0.1?
Russ Roberts: That's basically zero, basically. What is the real impact of that? That means that banks can borrow money overnight at a very low cost, right?
John Taylor: It feeds into all interest rates. Because if the mortgage rates are low and housing prices are increasing, it means there's really too much stimulus in the economy.
And, again, we have measures of this. It's not like it's never occurred before. It occurred in the 1970s. It occurred to the 2003, 2004, 2005. And, the other periods, they're pretty close. The other periods they have a higher interest rate. Some of the best periods in the United States were the late 1980s and 1990s, and those were the interest rate, it was very close to what you'd think it should be given the inflation rate, given the stance of the overall economy. So, I think what's different now is they're low.
And, the Fed knows this. They publish in their reports a set of tables, which has rules or procedures for setting the interest rate. One of them is a so-called Taylor rule.
Russ Roberts: Who's that named after?
John Taylor: I don't know.
Russ Roberts: I think it's John Taylor. But go ahead.
John Taylor: It could be, yes. So, they have strategies and they're off; but some are arguing they should be back. And, there's some dispute of the [?].
Russ Roberts: Somebody named Taylor is probably arguing that.
Russ Roberts: For those listeners who don't know, John Taylor's research was encapsulated, I would say, in the idea of what has come to be called the Taylor Rule, which is a relationship between the growth rate and the economy, the overall inflation rate and interest rates. And, you'll correct me when I'm done with this little summary, but it also has implications.
So, it's a descriptive statement about that there's a relationship between these things. And, that when they get out of whack--and you've alluded to that implicitly when you said things like it was way off--if there's a great divergence between the rate that the Fed sets and the rate that seems to go with the current level of growth and inflation, things ripple through the economy that are not so healthy. Is that a somewhat accurate summary?
John Taylor: Yeah. I think this so-called Taylor Rule--which has so many references, and it's now referred to a lot again--it's a very simple thing. It just says that it's a guide for the interest rate to be set. It's a guide. And, it says the interest rate should be higher if inflationis higher. So, the fact inflation is 4, 5, 6% says it should be higher. If the economy is doing poorly, it should be lower. If the economy's doing better, it should be higher. And, it's not just higher or lower, it's higher or lower by how much. So, you have magnitude. So, you can compare over time.
And, it assumes that the target inflation rate is 2%, which is what the Fed has said for a long time. There's a debate about what the normal interest rate should be. It could be 1, it could be 2. But no matter what you have--you know, the inflation rate is 4, or say it's 5. Just say it's 4. So, it gives some leeway. And, if the economy is still below normal, you want to take a little bit off that. Maybe take 1 percentage off. But inflation is better than 2, it's bigger than 2. So, add to that. And, when you add this off, you get a number like 5. I'll just say it, 4 minus 1 plus 1 plus 1 is 5%.
Russ Roberts: So, 5, you're saying should be the Federal Funds Rate?
John Taylor: That's if you assume inflation is 4. If you assume inflation is 2, the target, then it should be 3. Then the interest rate should be 3. This is a very simple formula. It's simpler than MV equals PY. It just has the interest rate and the state of the economy. It's very simple. And, that's why central banks refer to it so much.
Russ Roberts: So, the discrepancy between what, let's say the Taylor rule would suggest--which might be 4 or 5, something between 3 and 5, obviously inflation isn't 4 exactly. It might be 7 right now. It might be higher, lower. We don't know.
But you're saying that--the way I would summarize it is that the economy is, quote, "overheating," and we need to slow it down a little bit. And, one way to do that would be to raise that Federal Funds Rate which would bring inflation back down. Which would reduce the amount of dollars bubbling around and therefore bring the prices down lower.
What is the risk of having interest rates that the Fed sets too low at a time when implicitly in the past, the relationship should have been higher, 4 or 5% say? And, now it's close to zero. What's wrong with that? What's going to happen? What do you think is going to happen in the next six months to a year?
John Taylor: Well, one terrible thing that could happen is like in the 1970s where inflation kept higher and higher, and eventually the Fed said, 'This is enough,' and they did it. And, we had a terrible recession. Or maybe it was done in not the most smooth way. There was a debate.
I think the other time, which is maybe somewhat more debatable, is the 2004, 2005, 2006 period where the rate was low.
And, there's always reasons for this. There's always reasons why. It's not just coming from nowhere. So, it happens.
And, the concern is that will happen this time.
I do believe that a smooth adjustment, which is well-explained in telegraph--that's one of the advantages of having a rule or a strategy. 'Hey, I can see what's going on. I can see MV equals PY, like in my license plates there,' but they can also see this other simple formula, which is directed at the interest rate, starting with the shorter rate, but other rates, which everybody can see. Everybody can feel. Everybody talks about all the time. They don't talk about MV equals PY. They talk about the interest rate.
Russ Roberts: So, the risk would be that if inflation started getting increasingly higher, again, not just high at 7% relative to, say, over the last few years, but 7 and rising, that the Fed would be encouraged at some point to respond dramatically. It would have a sharp increase in the Federal Funds Rate, which would to a sharp contraction of activity by banks, which would lead to a sharp contraction of economic activity, which would lead to a recession. So, you're suggesting if they would start to raise it gradually now--they should have done it before--but it's not too late. They can start raising it gradually now and have a quote, "softer landing" to a lower rate of inflation in the future, rather than trying to bring it down dramatically in a short period of time. Is that a good summary?
John Taylor: Yeah, exactly right, exactly right. There's no reason why they have to go all the way instantly. These things take time and the intention--they talk about where they're going. That's why they publish these rules in the reports. They have something called forward guidance. They say what the average estimate will be of the interest rate.
For example, the average interest rate at the end of this year is 0.9. So, they do have some interest rates. Last year, just last September, they thought it was 0.3. So, they've risen from 0.3 to 0.9 at the end of this year. So, that's going in the right direction. But, again, 0.9 is relatively low compared to 3.0, which is really where they should be.
Russ Roberts: What is 0.9?
John Taylor: That's the Federal Funds Rate: 0.9 is what the interest rate will be according to what the Fed says, the average member of the FOMC [Federal Open Market Committee] at the end of 2022.
Russ Roberts: So, it's actually 0.1%, but some measure of expectations that will head to 0.9%.
Russ Roberts: So, the part that's hard, I think, for me--and I think for, certainly, for the non-economists--is the following. You're saying that the Fed is allowing inflation to rise and they have an opportunity to bring it down with their interest rate policy. They're ignoring that. They're taking a risk. There could be a lot of reasons for it. We don't need to go into that right now, but they're taking a risk. And, the risk is that inflation will rise even higher. And, the reckoning will be even sharper. That's what you're suggesting.
Now that's a statement about Fed policy, what it should be. And, you're suggesting they are making a mistake right now. But, does that explain why we have high inflation now? Right? In other words, I understand that if we have high inflation, if you were being agnostic about the cause, there's a way to bring it down with already[?] increasing the Federal Funds Rate. But, you're also suggesting, I think, that that 7% is caused by keeping that rate too low for too long. Is that correct?
John Taylor: Absolutely. No, absolutely. This didn't just pop up. These are numbers that have been there really in the last year, if you[?] say you want to think. And so, the risk is already there, 6% or whatever the inflation rate is, 4%, 7%. The risk is already there. And, the question is what's the best way to remove that risk. And, the best way to remove that risk is to raise the rate, not in a damaging way. It doesn't have to be damaging. If it's announced, if it's clear, if the reason they're doing it is clear. And it can be very beneficial. I think it will be more beneficial to the economy.
I mean, running at a zero interest rate, what's the advantage of that in the first place? So, if you have a normal interest rate, 2% or 3% or something like that, then the economy will function better overall. And, I think we'll have a more successful recovery. It doesn't have to be draconian. People are worried it will be because in the past it has, but it doesn't have to be. And, I think that as the Fed begins to make these adjustments, we'll have a better recovery than we might otherwise have.
Russ Roberts: So, I mentioned a while ago in our conversation, maybe 10 minutes ago that, individuals have their own experience of interest rates--either that might be in their mortgage; many of us look at our credit card. Our credit card charges us an interest rate to carry our balance over from month to month. And, it also rewards us sometimes with our purchases as a form of saving; that we have bank accounts where we store our money that have interest rates. That's what I really always[?] wanted to get to.
Has that ever been as close to zero for forever? I mean, my children who grew up in this low-interest-rate world--and I would add by the way, that for the last 50 years, it feels like, you'll correct me--but interest rates--nominal interest rates, that is the posted interest rates that are available to consumers and savings accounts and money market accounts--they've been trending downward. And, is that explained by inflation? Why didn't we have--well, my first question is, has the rates been at zero forever? Meaning, not--in the last few years, the last few years.
John Taylor: As I mentioned, they started to increase in 2017, 2018, 2019. But let me say: there is debate, for sure, about whether the normal rate should be as low as 4%, or maybe it should be 3%.
Russ Roberts: Normal rate of what?
John Taylor: Of the interest rate, the normal interest rate.
Russ Roberts: Set by the Fed.
John Taylor: The average interest rate. Yeah.
There is debate about that. And, John Williams--he is resident of the New York Fed now--has been part of that. But, even if you take all that into account, the rate--interest rate--is still too low. In other words, when I said it should be 5% or 3%, that's already taking into account that the normal rate is 1% rather than 2%, because in the so-called Taylor rule, it was always meant to be 2%. But there's been research of the Fed that argues it should be 1% or 0.5%.
Russ Roberts: Which should be 1 or 2?
John Taylor: The longer-term interest rate.
Russ Roberts: Okay. Oh, so not the--well, explain that.
John Taylor: Yeah. So, you normally think of the interest rate in a steady state--in the long run, on average--as equal to the inflation rate plus the real rate: inflation rate plus the real rate.
Russ Roberts: This is the nominal rate, as it's called.
John Taylor: The nominal rate is the inflation rate plus the real rate. There's no debate about inflation that's serious, but there is debate at what the normal long-run rate should be.
And, in the so-called Taylor Rule--it's 30 years old, by the way--it was 2%. But there's been debate in the last, maybe, five years it should be 1%. So, 2% rather than 1%. That means--my example before was 5%: it should be 5 rather than 6. So, 6 to 5, yes, that's because of the rate being lower in the long run, but it's still 5. It's not zero. It's 5.
So, just to point at the debate about what the interest rate should be in a steady state--in the long run, after we're all done the adjustments--is a very minor part of the issue about whether the rate should be now. It's a sort of a long-run versus a short-run. And, the short run are way off.
And, these terms, I know, are confusing. Economists use it in all different ways, equilibrium. The technical word sometimes is called r*. That doesn't help anything. But actually you could go to the Fed's report if any of your readers would do that. Most recent one has the rules right there. You can see it. It's not rocket science. You look at it. Everyone knows it's easier than high school algebra. It's sixth grade algebra, maybe fourth grade. So, it's easy.
Russ Roberts: But I want to try to, again, get at the intuition behind what we're getting at when we say it's way off or it's too high--or in this case way too low. It's saying that the Fed, through its overnight Federal Funds Rate--which is a short term interest rate--is going to ultimately stimulate the economy dramatically in a time when it is already being maybe a little over-stimulated in some sense. And, therefore, we want monetary policy to be a little bit contractionary when instead it's actually quite expansionary; and that is likely to lead to higher rates of inflation in the future. Is that right?
John Taylor: Yeah. The only correction I would've said--I'm not arguing it should be contractionary. It should be normal.
Russ Roberts: Less in expansionary, maybe?
John Taylor: Yeah. Yeah. Less--too much stimulus. Just normal. It should be what worked in the past very well. So, we could go back. We used to have this term, the Great Moderation that's referred to a good monetary policy in late 1980s and 1990s into just the early part of the century. And, that's the policy that we need to get back to.
And, by the way, during that period, the so-called Taylor Rule was right on. I wasn't complaining. I didn't write much about it. But it really worked. And periods where it's gotten off as the problem. You know, it's not a rocket science, but it's remarkably close.
Russ Roberts: So, there are a lot of people that have their own theories of inflation and monetary policy. Most of them aren't at Stanford University as you are. So, you're kind of a serious--I would say it differently: Everyone has to pay attention to you and take you seriously. Like you said, it's in the report.
John Taylor: You don't have to, you don't have to.
Russ Roberts: No, but, why don't they? My question is: This is not a secret. It's not like, 'Oh, John Taylor is some crank about this relationship between the interest rate and the growth rate, the long term rate and the short term rate. He's a pretty serious guy. He's on the short list for a Nobel Prize'--and should get one, I just want to add. But why aren't they doing it? Don't they know? They know. They know they're way off. What are they thinking? Do they disagree with you? Are they trying to achieve a different end? They're willing to tolerate some inflation to get something else to return? What do you think is going on?
John Taylor: Well, first of all, we have a very serious pandemic and it hurt the economy. No question about it. And, they reacted. I've never complained about the reaction taking the rate down to zero.
The complaint in the dispute is really where they are now. And I think it's--again, it's a complicated institution. They've used rules or strategies more and less over time. And, there could be, 'Oh, we're worried about this terrible plague hitting the economy again.' It could be that argument. It could be that there's other things to worry about. It could be politics. It could be also sorts of things.
And, so, the main thing, I'd say one of the advantages of having a rule or a strategy that the central bank--and by the way, it's not just the Fed. It's central banks all over the world. It's the same. It's really the same formulas, a little bit of adjustment. Then we would have agreement on what works and what doesn't. We wouldn't have Zimbabwe's. We wouldn't have Venezuela's--for sure. We'd have a better policy. So, that's the idea.
Russ Roberts: That's the worries of hyperinflation.
John Taylor: Yes. We wouldn't have situations like that.
And, hopefully, more will come to it. But again, it's not the first time. There's other things that central bankers looked at. I think the current Chair spoke very favorably about this approach early on. And, now I think he's had to worry about other things. But maybe he'll come back to this. We'll see.
Russ Roberts: You mentioned fiscal policy in passing. Going back to, certainly the early days of--well, actually I'm going to go back even farther: I was going to say, of the Trump administration. Let's go back to Obama. We've been running very, very, very large deficits--fiscal deficits, meaning the government spends more than it takes it in taxes. And, it usually closes that gap by borrowing. But it also can close that gap by effectively--not effectively--essentially printing money. Is that what's going on?
I mean, doesn't monetary and fiscal policy merge to some extent and have they in the last 15 years or so as the United States has relentlessly very often spent beyond its means? There's always an excuse. There's always an argument. And, to be honest, I've been surprised at how well the economy has absorbed those very, very large deficits. I know it's something you're worried about. Should we be worried about them? Do they have implications for monetary policy? Do they have implications for inflation? Are they relevant at all?
John Taylor: Well, they don't have implications [for?] monetary policy if the central bank follows [the?] kind of strategy or rule that I indicated, because it's not the deficit's not there. But you asked about what could cause deviations from that. And, maybe fiscal policy is one of them. We had trillion dollar deficits with President Trump at the end, and they continued. So, I think that's a bit of a problem for the economy itself. It'd be better if we had a lower deficit. I think the same is true right now. What good do these deficits do? A whole other part of my writing is to examine the stimulus packages, and there's been three counting one with President Biden, two with President Trump. And, as far as I can say, they didn't really help at all: the people were saving and you can see it in the data and very clear.
So, that's a whole other thing of fiscal policy. It'd be better if we had a fiscal policy that was more in line, more pro-growth if you like. And at this point, I think that means moving towards a smaller deficit. And, there's big debates about that as you know, in the United States.
But, I wouldn't point that as the number one reason, or even a really high reason for the Fed to be behind the curve. I don't think they need to be. And, it's not something that's stated in their--and they have reports. Your viewers or listeners can go look at them. They're right there in plain daylight in there: they don't have fiscal policy.
Russ Roberts: Stick with fiscal policy for a sec, just because this is the other issue I know you're very interested in. John for listeners who don't know him, he is a macroeconomist. He cares about both monetary and fiscal policy and his work in monetary theory is a little more celebrated in the sense that he doesn't have a rule in fiscal policy named after him. But, okay.
But, when we think about fiscal policy, you have been for a long, long time, very worried about the size of the deficits and the resulting debt level relative to GDP. A lot of people on the other side of the political fence have said, 'This is nothing to worry about. The United States can live beyond its means. It's not like an individual. We're only borrowing it from ourselves. There's really no harm.' And, if you look at the world, you could say, 'Well, they look right, so far.' Do you think they're going to be--for me, my view on it is, is that deficits for a large country, like the United States that has quite a bit of monetary authority and that people like to hold dollars as a store of value and will not flee from them without a really attractive alternative with a stable economic and political system. Yet, someday, there might come a day, where people don't want to buy American bonds. And, that deficit, which looks benign becomes disastrous. Is that your forecast--eh, not forecast. Is that your concern?
John Taylor: It's a concern. Again, we have history where a better fiscal policy has been where you don't have the deficits. On average, you have a balanced budget--means you have deficits and recessions; you have near-surpluses and good times. It's a good system: You can think as a rule, as a strategy for doing that, it makes sense. It's worked pretty well.
And when you get off that, you have the debt rising as a share of GDP. That means interest costs will go up eventually for the government. And, I think it's a better policy. I don't have the same calculations as a so-called Taylor rule, but they do suggest that a better policy would have a near balanced-budget on average. So, you have surpluses and deficits. But we're not there yet.
And, I'm not sure we will be there. So, we'll sacrifice a somewhat higher debt: the GDP ratio--debt-to-GDP--will go up because the debt is rising faster than GDP. And that's a concern.
But, the main concern now, I'd say--I mean, that would be very important--but I'm more concerned about the Fed and getting the Fed in line. Sorry to keep going back to that.
Russ Roberts: Oh, that's all right. I'm restraining myself for making a PG-13 [Parental Guidance for film-viewing recommendations by the Motion Picture Association film ratings being age 13 and up] joke about Robert Solow and Milton Friedman, but listeners with some background can send me an email if you want.
Russ Roberts: Let's talk a little bit about the--COVID, the recession that was caused or was the result of lockdowns. It's a very different kind of recession. It wasn't a--in a way, it was not a decentralized situation where millions of actors--as consumers, employers, employees--were responding to economic changes that set a bunch of other things into motion as a result. This was a plague that the government and the citizens decided was a good time to stay home. And, then when it got relatively safer--as we got vaccines and more benign types, variants, of the coronavirus--people said, 'Well, okay, I think it's time to go back to work.'
Some of them didn't. They decided they liked--literally, didn't go back to work. They worked from home. Massive set of changes that has rippled through the economy. And again, many of them manifest themselves in the form of something that's rare in our lifetime: empty shelves, as you mentioned, alluded to earlier; cargo ships queuing and bizarrely-large numbers at American ports. It's amazing to me that this has not in and of itself caused an immense amount of economic disruption. Why has the economy been so resilient?
Now, I think Keynesians--of which you are not a standard kind; and, I am definitely not one either--Keynesians say, 'Well, it's easy. The government spent all this money, all that fiscal policy that you mentioned earlier, they borrowed a lot of money. They gave it to citizens. They gave it to businesses to keep employees on payroll and that Keynesian stimulus kept the economy from sinking.' Do you share that story?
John Taylor: I don't. It's because I've studied it. I've looked at it. You don't have to just wave your hand.
Russ Roberts: You mean, I can't just tell stories--
Russ Roberts: and feel good about myself? Come on. That's the essence of economics.
John Taylor: You make the rest of us--keep it up. You make the rest of us feel good. But you also couldn't have data that supports this view. And, that's what I've tried to stress.
And, I think the other thing is the resilience of the economy is quite terrific. I mean, a lot of my courses have been online or I had last fall in person with masks. But, online is terrific. And, you know this from your own work, Russ--you probably know at the university--there's an amazing ability for people to supplement. And, I think the[that?] Zoom is a big part of it. Mr. Zoom is just a few miles from here, Eric Yuan. And it's a tremendous benefit.
So, I think what's happening, yes, people are working at home. They're living in Manhattan and working at home rather than going to the office; but you're actually doing a lot of work.
Now, obviously, it's not going to be completely online in the future, but I think there will be a hybrid. And, to some extent, I think we've seen the economy bounce back because people find other ways to do their work, otherwise to commute.
Now, we're not over this to be sure. I mean, there's a lot of Stanford students who are being diagnosed with the disease. And, so, we're trying to take that into account. But I think what you're seeing is an amazing ability for the economy to interact.
I would also say there's these high tech firms. There's Google, there's Facebook, there's Apple. And they happen to be nearby as well--it doesn't matter. But they're global. They're just a tremendous benefit.
So I worry--there may be a tremendous benefit--may be another episode, maybe you've already done this, Russ--is: What's the story with these firms? Should we be encouraging them to do more? They--stifling free speech. But I think that there's enormous benefit from that. And, we can, you can use that. It's not macro so much, except that it's emphasis on markets and on freedom and on the ability to use the price system effectively. And, I think it's a very promising thing. It's monetary and fiscal policy, generally. It's regulatory policy. It's continuing to allow these firms to operate and to do what's good.
Now, to be sure this controversy, it's bipartisan complaints about many of the firms. But I think the more that there can be a serious discussion of what they're doing and the benefits. And, I think that's one of the reasons why that some countries have done well out of this, others still have a long way to go. That's the sad part of this. We're not done. I think a lot of parts of Africa are still struggling, and we may struggle more ourselves.
Russ Roberts: I just want to come back to your point about the data. You know, when I made my--I will not call it a back-of-the-envelope calculation--but after-this-therefore-because-of-this, which is a classic fallacy, post hoc ergo propter hoc, after this, therefore, because of this--obviously, you can't just look at something that happened concurrently or shortly thereafter or long time after and say, 'Well, it must have been caused by that.' But, I do think that the people who have defended the stimulus packages would argue that they have data, too.
So, One--we can close on this one--I'm curious what you think is distinctive about--how would you summarize why your case that that was ineffective is correct? Is it a timing issue? Is it a magnitude issue?
And, then secondly, is there stuff you've written that we can link to that viewers who are not technically proficient, who are just casual consumers of economics, not grad students and professional economists, that they could read and enjoy?
John Taylor: Absolutely. Actually, a lot of it is just looking at some charts and you can see these big infusions of money, which didn't affect consumption at all. There's three. There's two with Trump and one with the Biden. And these were--they were pretty much one-time payments. They tried to limit it to people who were not so wealthy. But, if you just look at the data, the consumption didn't go up. It stayed pretty steady.
Russ Roberts: People saved it. So, people saved it.
John Taylor: Yeah. Yeah. And, as far as we can tell--I mean, obviously they didn't save every penny and not everybody--some people used it. But in general, this was not--these three so-called stimulus packages, as far as I can tell, looking in detail of the data, were not stimulative.
Now, it doesn't mean other things the government were doing--maybe this bipartisan infrastructure program had a difference. That's relatively new to investigate. But the others did not. I don't think there's any dispute about it.
Russ Roberts: Are you optimistic about the future of the U.S. economy? I am anxious on political grounds for the future of the United States. And, I think that has implications for the free economic policy. They don't work totally independently. What do you think?
John Taylor: Well, I'm more optimistic than I probably should be, but I think that we're in a situation where we're having a good discussion. We're having debates. Maybe it's more pulled apart than normal. I hope you're dealing with this incredible partisanship that we see.
But I can't be too pessimistic, because unless the disease comes back or something like that, I think we're following the right approach. And, I think if you compare it with other countries, it's looking better.
The danger is: there's a lot of risk. That's for sure. We could regulate, we could, could get confused. We could have a terrible monetary policy.
All those things are risk. But I think the data and the analysis is suggesting we need to improve policy--monetary policy. We need to improve fiscal policy. You've seen the debates about that, too.
A regulatory policy is harder, but I could there I could give my examples of the high tech firms; and let's not try to prevent them from doing the good things.
And, so, I'm optimistic that it is a terrible tragedy that the world has faced, but I think we're going to come out of it fine.
Russ Roberts: My guest today has been John Taylor. John, thanks for being part of EconTalk.
John Taylor: Thank you, Russ. Thank you very much.