Noted monetary theoretician John Taylor, an economics professor at Stanford University, addressed the 30th Annual Monetary Policy Conference at Cato Institute about what can be learned from the past 30 years of monetary policy that would be useful for formulating policy for the next 30 years.
In a nutshell, Taylor proposed dividing the period into the first two-thirds, characterized by considerable economic growth, and the last third, “where economic performance has been just egregious.” In that last third, according to Taylor, “monetary policy has gotten off track.” The objective, therefore, should be to get back to the monetary policy of the first part of the period.
He pointed to a period from the mid-1980s, lasting about 20 years, called the “Great Moderation,” where economic growth proceeded at a stable pace before coming to an abrupt end in 2008. A similar pattern can be found globally.
Looking at inflation, the rate came down dramatically during the period, but it was followed by a period he called “too low for too long,” where interest were held at a low level for an extended period, a condition that encouraged risk taking and fueled the housing boom. He acknowledged that the Federal Reserve disputes this analysis, but Taylor found that the Fed’s policy regarding inflation had changed from that of the early period.
During the panic of the fall of 2008, he said, the Fed’s dramatic action to supply liquidity to the market was appropriate, but he argued it should have been removed quickly instead of being followed by an extended period of quantitative easing (QE).
Referring to the “huge amount of controversy” over whether QE has helped the economy, Taylor stated that his own research does not find beneficial results for the economy other than so-called “announcement effects” that are of short duration.
The effects could even be negative, and he cited remarks by David Malpass about the “two-sided” risk that removal of the stimulus could be contractionary, whereas if it is kept in place, it could lead to higher inflation. Taylor complained that such a policy is discretionary, as opposed to the rule-based policy he advocates that would allow interest rates to rise in order to control inflation.
Furthermore, he decried the fact that the liquidity the Fed is supplying is going to help particular sectors and that it helped finance the fiscal deficit in 2011 to the extent of 77 percent. The effect has been “to change the nature of monetary policy” and lead people to question the Fed’s independence, something to worry about.
An aspect of the policy deserving closer examination, Taylor continued, is the so-called “zero bound,” meaning that when the Federal funds rate (FFR) gets close to zero, the Fed employs other tools to support the economy, which has been QE.
Referring to information provided by Vice Chair of the Board of Governors of the Federal Reserve System Janet Yellen, Citigroup economist Bob DiClemente evaluated two policy rules for the FFR to look at how the Taylor rule would have performed between 2005 and 2015. The Taylor rule stipulates how much the central bank should change the nominal interest rate in response to changes in inflation, output or other economic conditions. In particular, the rule stipulates that for each 1 percent increase in inflation, the central bank should raise the nominal interest rate by more than 1 percentage point.
DiClemente’s research shows that the FFR would begin to lift off and would rise toward about 3 percent in 2015, whereas a so-called “modified Taylor rule,” according to Yellen, would have called for -6 percent to -7 percent interest rates in response to the high level of unemployment that accompanied the Great Recession. Thus the stated rationale for QE.
Taylor challenged the use of the “output gap” by Yellen and others to justify stimulus as unreliable and called instead for a zero response, as opposed to the aggressive actions by the Fed.
A related issue Taylor discussed was the role of “forward guidance” by the Fed as to how long it plans to keep accommodative policy in place. He asserted that if the Taylor rule were followed, the forward guidance would be unnecessary, whereas providing it introduces “a huge amount of uncertainty,” for example, as to whether the stated intention to keep rates near zero until 2015 is a “commitment” or merely an “intention.”
In summary, Taylor characterized current policy as involving “a huge amount of discretion, which is detrimental” compared with the periods of good performance of the earlier period.
Instead, he advocated that when the zero bound was reached, the correct response would be a “Friedman rule” based on money growth, given that interest rate rules were the result of an effort to improve on the more basic money growth rule that Milton Friedman advocated in order to avoid large fluctuations in money growth. Taylor laments that this did not happen.
His response to the frequent question as to whether the Fed has no gas left in the tank to help the economy is, no. Instead, he said, “The economy would benefit enormously to a return to policies similar to those that produced more consistent positive growth in the past.”
Robert Feinberg served on the staff of the House Banking Committee for the 10 years that encompassed the savings-and-loan debacle and the beginning of its migration to the banking sector. Subsequently, he has consulted on issues related to the crisis for law firms, accounting firms, securities firms and trade associations.
Feinberg holds a BS.E. from the Wharton School and a J.D. from the Law School of the University of Pennsylvania. He has drafted dissenting views on landmark banking legislation, contributed to a financial blog and written hundreds of reports for clients to document the course of the financial crisis as it has unfolded over the past three decades.
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