The Taylor Rule

by Mark A. Monoscalco

In the 4/23/12 issue of Barron’s Gene Epstein interviews Stanford University economics professor John Taylor.

The complete interview is at this link:


Fiscal Follies, Monetary Mischief

John Taylor is perhaps best-known as the creator of the “Taylor Rule,” which seeks to determine the Federal Reserve’s interest-rate target according to a simple formula.  This is a very informative interview, here are some of the most important points:

Barron’s: What’s the best case you can make on behalf of those who defend the recent fiscal stimulus?

Taylor: The case that has been made for the discretionary fiscal stimulus is based on quite conventional Keynesian theory. It is basically that, if the government gives people a lot of extra money on a one-time basis, they will spend it. Not all of it, but most of it. Similarly, when the federal government gives money to states and localities as part of the temporary fiscal stimulus, it will be spent in such a way as to boost gross domestic product. And that will greatly help when economic activity is otherwise either contracting or stagnant.

 My own view is that the theory is flawed, and the evidence that the fiscal stimulus achieved the desired result is practically nonexistent. The surge in federal spending only increased the burden of the already burdensome   federal debt.

Let’s start with consumer spending. It’s basic economic theory that most people look beyond the very short-term. To expect them to rush out and consume more when the government cuts them an extra check on a temporary basis is not realistic. Instead, they will bank most of the extra money or use most of it to pay down debt.

But let’s even imagine that, with temporary tax cuts, consumers do spend all the extra money at the malls. Can we expect business to respond by hiring more workers on a lasting basis? Of course not. Businesspeople will know better than anyone that the pop in spending won’t last.

 Barron’s: But if, as you say, consumers and local government used to the money to reduce borrowing and pay down debt, could that be a completely bad thing?

Taylor: It can’t be bad to reduce the debt of consumers and of state and local government. But it can’t be good to boost federal debt in the process by the same amount. So that’s a wash. It’s really hard for me to see it as a net positive.

 Barron’s: Right now, the Federal Reserve’s official interest-rate target on federal funds is 0% to 0.25%. Is that where the target should be according to the Taylor Rule?

Taylor: No, the interest-rate target would be at 1%, or a little higher. That is based on starting with a multiple of the inflation rate, and then adjusting up or down for the growth rate of the economy compared with its potential growth rate. Right now, the growth-rate part of the formula would call for a downward adjustment, so you end up around 1%.

The Taylor Rule is based on empirical research about what tends to work best for the short-term interest rate. It is far from perfect. It just works better over the long run than the discretionary tinkering of imperfect human beings. And in fact, through most of the period from the early 1980s through 2002, when the economy performed relatively well, the central bank’s interest-rate target tracked the Taylor Rule fairly closely.

 Barron’s: But not since then. You have said that during the period from 2003 through 2005, the fed-funds rate violated the Taylor Rule by being too low.

Taylor: Yes, at times by as much as three full percentage points. And that helped cause the financial crisis, as I have argued in my book Getting Off Track.

 Barron’s: On another important component of Fed policy, what do you think of quantitative easing?

Taylor: I opposed the large-scale asset purchases of QE1 and QE2, and believe it’s unfortunate that the central bank is still publicly considering a QE3. They were ineffective, and potentially harmful.

These massive purchases of mortgages and medium-term Treasuries were aimed at lifting the value of these fixed-income securities, and thereby bringing down the relevant interest rates. At best, that was the short-term effect. But how long can such an effect last? What basically determines these interest rates are expectations about future interest rates, which in turn are partly determined by inflationary expectations.

 Barron’s: You don’t believe purchases by the Fed have any long-lasting influence?

Taylor: Let’s suppose something even more misguided: For QE3, the Fed decides to buy the stock of publicly traded companies in order to lift stock prices. Equity prices would rise. But how long could that last, unless the earnings of these companies rise proportionately? Price-earnings ratios would become unsustainably high, and the market would soon correct for the Fed’s aberrational influence. The same dynamics work for the bond market.

But my real worry is that quantitative easing may become a pillar of Fed policy. If the economy speeds up, you do less of QE; if it slows down, you do more. Quantitative easing may become not just the wave of the present, but of the future, which could be very damaging.

 Barron’s: What’s the basic lesson for both fiscal and monetary policy?

Taylor: Both policies should be predictable, not discretionary and unpredictable. It is always possible that some brilliant policy maker can do something unpredictable that will yield a better outcome. But history has shown us repeatedly that this usually yields worse outcomes. My new book, First Principles, names “policy predictability” as one of five key principles.

Barron’s: And the other four?

Taylor: Rule of law, strong incentives, reliance on markets, and a clearly limited role for government.

John Taylor makes a broad statement that “conventional Keynesian theory is flawed and that the evidence that the fiscal stimulus achieved the desired result is practically nonexistent”.  It is time that we toss this failed policy into the waste bin of history.  He also says that the Federal Reserve kept interest rates too low for too long igniting the housing market bubble.  His five principles for prosperity are intuitively obvious but unfortunately are considered radical by many of our fellow citizens.

Mark A. Monoscalco is a member of the Grassroot Institute of Hawaii. His personal blog, from which this is re-posted, can be found at http://defendingcivilsociety.blogspot.com.

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