The Big Think has just posted an interview with John Taylor, and he provides some very interesting answers to my questions on monetary policy. Before I try to systematically demolish his response, let me first say that I agree with John Taylor on most things, including most of his answers to questions raised by others:
1. Fiscal stimulus was not very effective, and led to a counterproductive increase in the national debt.
2. The Fed should focus on monetary policy, rather than supporting the housing market.
3. The big mistake was not the failure to bail out Lehman, but rather policy errors a few weeks later.
4. The State of California needs to curb the growth rate of spending.
5. The Fed should not focus on asset bubbles.
So we agree on most things. But with all due respect I think his attachment to a backward-looking Taylor Rule has led him into all sorts of blind alleys.
Taylor responded to two of my questions. I will quote in full, breaking occasionally to interject my own views:
Question: Is it better to have price level targeting or inflation targeting in a liquidity trap? (Scott Sumner, The Money Illusion)
John Taylor: I think the distinction between price level targeting and inflation targeting, which has had a huge amount of attention in the academic literature and has been referred to in the past, such as Ben Bernanke before he became Chairman. I think those distinctions in practice get blurred by the realities, quite frankly. It of course would be good to have a price level targeting other things equal that would sometimes require deflation, however, and a lot of evidence that that’s not such a good thing to have; even occasionally.
So, I’ve always been of the view that an inflation target makes more sense, it’s easier for people to understand, we’ve had a lot of practice with it. And while there is this problem of lack of a drift, the drift of the price levels sometimes called base drift, overall seems to me if we were able to keep the inflation rate at a very low level, then we would effectively get similar results to price level targeting.
What do you think? It doesn’t seem to me that he addresses any of the reasons Woodford puts forth for price level targeting in a liquidity trap. Just to review, Woodford argues that with an inflation target, monetary policy has no traction in a liquidity trap. Assume the inflation target is 2%, but also suppose inflation keeps coming in under 2%. How does the Fed react? Under inflation targeting the only answer is “try the same thing again, and hope for better luck next time.” With price level targeting, if you undershoot the 2% price level growth trajectory the target inflation rate automatically rises. If nominal rates are stuck at zero, sub-target inflation automatically lowers the real rate. Does Taylor’s response address Woodford’s argument? Maybe I missed something, but it seems to me that Taylor’s answer referred to the opposite situation, where inflation has exceeded the target. Next question . . .
Question: Should the Fed have been more aggressive with monetary stimulus in September-November 2008? (Scott Sumner, The Money Illusion)
John Taylor: I think the Fed cut interest rates during that period just about right. I think it was basically coming down, it could have been a little faster at that point, and of course, GDP did fall tremendously. But I think if they had kept the interest rates along the same path it would have been fine.
Now stop right there. I didn’t ask whether the Fed should have had lower interest rates, I asked whether their policy should have been more stimulative. Of course Joan Robinson would say that nominal interest rates and monetary policy are one and the same. Joan Robinson would say that monetary policy was not easy during the German hyperinflation, after all nominal rates weren’t very low. Am I being unfair to John Taylor? In one sense yes. The inventor of the Taylor Principle clearly understands the distinction between nominal and real interest rates as well as any person alive. But then when I asked about the stance of monetary policy, why did Taylor not criticize the Fed for dramatically raising real rates between July and November 2008? Why did he merely talk about changes in nominal interest rates, as if they provided meaningful information about changes in the stance of monetary policy?
A few months ago I had a series of posts basically calling out the entire monetary economics establishment. I accused them of throwing around terms like ‘easy money’ and ‘tight money’ without assigning any coherent meaning to the terms. Taylor’s answer is a perfect illustration of what I was complaining about. I still await an answer as to what these terms mean. I might have to offer a $200 reward as a cheap stunt, just to generate some interest. How hard can it be to define the stance of monetary policy? How hard can it be to explain what we mean by ‘easy money’ and ‘tight money?’ Apparently it’s pretty hard, because no one has yet been able to answer my question.
Taylor continues . . .
The problems I see at that period was the tremendous amount of uncertainty added by these new effects, if you like, the quantitative ease, and sometimes I’ve called somewhat **** industrial policy to where the actions went well beyond the usual interest rates. And I don’t think they were appropriate. We’re still studying them. Some of them were inappropriate. I just finished a study on mortgage interest rates.
I agree that we wasted precious time focusing on non-monetary issues during September-October 2008. Taylor continues . . .
So, the question about whether the policy could have been even easier going into the panic, it is certainly something to examine, but I think basically, it’s about all it could do at that point. The problems I saw were not so much a monetary policy at that stage, but the really ad hoc chaotic interventions that occurred around the time of the rollout of the TARP, not clear kind of actions with respect to what happened to Lehman Brothers. So, a lot of surprises and ultimately a lot of panic. And I think that panic was induced as I’ve argued in other places by government actions. I think some of the actions of the Fed after the panic began were constructive to be sure. But I don’t see that in terms of a faster reduction in interest rates.
I absolutely agree that the government was creating a lot of panic. If I was running a highly leveraged commercial or investment bank, and I saw NGDP growth expectations rapidly plunging into negative territory, and I saw the Fed making no effort to adopt a more stimulative policy, but instead adopt an interest on reserves program to prevent reserve injections from having any effect, well then I’d panic too. But those aren’t the actions that Taylor thinks created the panic. Rather it was Bernanke and Paulson’s admittedly clumsy efforts to save the banking system. The reason we both felt that late September and early October was important was that it was during this period that asset markets showed panic. And we even agree that it was related to Fed actions. But Taylor (and Cochrane) seem to think it was what they said that was causing panic, whereas I think it was the fact that they got distracted from monetary stimulus. Throughout history there are many examples of tight money policies severely depressing the stock market. I simply don’t think it is plausible that a few clumsy regulatory moves that were quickly reversed under political pressure could have severely depressed equity prices. There’s no precedent for that. That’s not how the stock market works. It is not that sensitive. Oddly, on this point I agree with Paul Krugman (as does Tyler Cowen.)
Taylor continues . . .
In fact, if I could just add. One thing I think people should recognize is that while the federal funds rate target of the FOMC came down gradually in the fall of 2008, the actual rate came down quite a bit more rapidly. In fact, each of the FOMC decisions effectively ratified what the rate was already at. And that rate came down so rapidly because of the large expansion in the reserves. So, it’s hard to see how measured in terms of interest rates policy could be much easier in the October, November, December period.
The fact that the Fed was scrambling to catch up to market rates is one indication of just how far behind the curve it was in the fall of 2008. But the last sentence was a big disappointment. Taylor previously indicated that policy was fairly expansionary in late 2008, and ended his answer by suggesting that there wasn’t much more the Fed could have done. In contrast, I think monetary policy was highly contractionary, and that the Fed could have and should have been much more stimulative.
So how does the Taylor Rule hold up in the crisis of 2008? The first question to be answered is which version of the Taylor Rule? I seem to recall that Taylor likes to cite the “Marshall McLuhan” scene in the old Woody Allen movie, so I’ll assume the Taylor Rule is whatever the hell John Taylor says it is. Here’s how I see things:
1. In October 2008 I was running around calling for a much more expansionary monetary policy.
2. John Taylor seems satisfied with the stance of monetary policy in October 2008.
3. In 2009 NGDP fell at the fastest rate since 1938.
In retrospect, would you say I was right in calling for more monetary stimulus, or was Taylor right?
I do think the Taylor Rule works reasonably well when you are not in a liquidity trap, although even in that case I think NGDP futures targeting is superior. But if there is one thing we have learned in the past two years it is that the Taylor Rule provides absolutely no guidance to policymakers when interest rates approach zero. Indeed I believe it quite likely that the “panic” Taylor refers to in early October 2008, which was very real, was caused precisely by the fear that the Fed would adhere to the Taylor Rule, and would not adopt the sort of policies that Bernanke had recommended the Japanese try once their rates hit zero.
PS. If you haven’t read my earlier posts on monetary policy, I should clarify a few things. I know full well that Taylor and others understand the distinction between real and nominal rates. But they insist on continuing to discuss the stance of monetary policy with reference to nominal rates. As long as they keep doing so, I will keep needling them with my insulting Joan Robinson comparisons.
I am not saying that real interest rates are a good indicator of monetary policy. Rather that’s what others often say when I point to the flaws with nominal rates. My point is “OK, if real rates are the right indicator, then why no criticism of the Fed’s extraordinarily contractionary policy during July to November 2008, when 5-year real rates jumped from 0.5% to 4.2%?”
In my view the only meaningful indicator of monetary policy is the expected growth in the policy target variable, which I think should be NGDP.
Tags: Taylor rule