Procedural Interest in the Taylor Rule
John H. Cochrane and John B. Taylor [Rules vs Discretion, the SSF series]
PART 1:
On the May 2022 annual Hoover monetary policy conference:
… Why did the Fed take so long to move now? There are many answers to this question, and I won't go deep into it. One of the features was likely forward guidance, which the previous panel alluded to. The Fed kept rates interest rates low because the Fed said it would keep interest rates low. There was this elaborate formal new strategy that said we're going to keep interest rates low. That strategy was, I think, a beautiful Maginot Line crafted against deflation but, as with the original, it forgot: what if the Germans come through the Ardennes instead?
We discovered [at the conference?] a halfway point between Larry [Summers] and John Taylor. The problem of forward guidance is, does anyone believe the Fed will do it ex post? (Time consistency.) Critics like me who said no I think were proved wrong. The Fed held itself ex post to a good deal of what it had promised. Unfortunately, it promised something that was inappropriate in the circumstances, which is the whole point and conundrum of forward guidance.
And what John [Taylor] would say is, well the Fed should have had promises that include, if a serious inflation breaks out, inflation, then we'll do something else.
The Fed in general does far too much “here is what we think will happen so here is what we are going to do,” and far too little contingency planning in case things don’t work out the way it projects. Which, we have just learned, can happen in large measure and with dramatic speed. Military planners know this. They red-team their projections, obsess over unlikely contingencies, and follow failures with detailed self-critical investigation. The Fed should also …
… I think this graph encapsulates the view the Fed is way behind the curve; that low interest rates below inflation constitute additional stimulus. Inflation spirals off, at least until it gives in, raises rates sharply and causes a recession, as Larry Summers warns. That looks pretty awful. And it looks like the Fed is completely wrong in its forecasts of what will happen if it follows this fund rate path.
But what if expectations are rational? Here's a little modification of the model with the arrows pointing to the changes. What if, the real interest rate and the Phillips curve are centered at expected future inflation rather than lagged inflation? Same simulation: Put in the federal funds rate path, anchor inflation at last year's inflation. Turn off all shocks. What happens? I obtain almost exactly what the Federal Reserve is projecting.
Intuitively, the rational expectations Phillips curve looks at inflation relative to future inflation. Unemployment is low, as it is today, when inflation is high relative to future inflation. Inflation high relative to future inflation means that inflation is declining. And that's exactly what this projection says. Rational expectations means you solve models from future to present. If people thought inflation was really going to be high in the future, inflation would already be high today. The fact that it was only five percent tells us that it's going to decline and go away.
To be clear I don't think the Fed thinks this way procedurally. They have a gut instinct about inflation dynamics, informed by lots of VAR forecasts and model simulations. But this theory gives a pretty good as-if description, a slightly more micro founded model that makes sense of those intuitive beliefs.
So the Federal Reserve's projections are not nuts! Inflation might just go away on its own! There is a model that describes the projections. And this is a perfectly standard model: it’s the new-Keynesian model that has been in the equations if not the prose of every academic and central bank research paper for 30 years. So, it is not completely nuts. Our job is to think about these two models and think about which one is right about the world.
To put the question in another way, let’s find what interest rate it takes to produce the Fed's inflation projection. What should the Fed be doing? With adaptive expectations, to make inflation fade away as the Fed thinks will happen, we need the interest rate to be nine percent. Right now. Why? Because you need a high real interest rate measured relative to lagged inflation in order to bring that inflation down. And we're way, way off the curve.
I think this calculation encapsulates a lot of the ‘Taylor Rule’ view …
… Now, what can the Fed do about inflation? Suppose the Fed does start raising interest rates aggressively? Here I feed the model an AR(1) interest rate, with no fiscal policy shock, to evaluate the independent effect of monetary policy. Many models implicitly specify that when the Fed raises interest rates there's a big increase in surpluses. We're just going to leave fiscal policy alone and see what happens in what is apparently the Fed’s model, if the Fed raises interest rates.
The interest rate rise does lowers inflation, but only in the short run. There's a form of Tom Sargent’s “unpleasant arithmetic” at work. Lowering inflation today raises inflation in the future. We had a fiscal shock. That has to come out of the pockets of bondholders, by inflating away bonds. The Fed can choose to inflate that away now or inflate it away in the future. But the Fed cannot get rid of the fact that there has been a fiscal shock which inflates away debt. So it has a limited power. It can smooth inflation but cannot completely get rid of inflation.
What if there is a 1% fiscal shock, but the Fed responds with something like a Taylor rule? We basically add the last two figures. We get lower inflation in the short run, but much more persistent inflation in the long run. Smoothing inflation is a great thing in this model. It reduces output volatility. (Output is related to inflation relative to future inflation, so has almost no movement here.)
We have one more reason for a Taylor rule: It does not give us stability, as it does in adaptive expectations models, it does not give us determinacy as it does in new-Keynesian models. It gives us quiet, the absence of volatility, which is perhaps the best of all.
And we've seen that failure in Latin America. Countries get into fiscal problems, they have inflation, they raise interest rates, that just raises debt costs, and the inflation spirals on up …
… In my reading, we have crossed the Rubicon. We have found the point that people didn't want our debt anymore, started to spend it, and caused inflation. Are we now at the fiscal limit where we can't do a big deficit-financed stimulus again? Or do people, can people, think that future deficits will be repaid by even further future surpluses, and they will happily lend those trillions without inflation?
PART 2:
JOHN B. TAYLOR
RULES VERSUS DISCRETION: ASSESSING THE DEBATE OVER THE CONDUCT OF MONETARY POLICY [an NBER WP PDF file]
John Taylor wrote in 2017:
For the Taylor rule the inflation target was 2% (taking in to account inflation measurement bias and the zero lower bound on the interest rate), and the equilibrium interest rate was 2% in real terms and 4% in nominal terms. The rule was not the result of a curve fitting exercise in which various instruments of policy were regressed on other variables. This simple rule was derived from first generation policy models operating in “rule-space”.
To this day people say that such rules are too simple because they omit certain variables. Well, they were simple, because they were made to be simple. At the time people were coming up with all sorts of complex rules that included many types of variables, including asset prices. These rules were too complex to be workable in practice. It was amazing that they could be simplified. Rules from which certain variables were removed gave just as good a performance in many models as more complex rules. Simple rules were more robust than optimal rules over a wide range of models, and they were certainly something more practical for policy makers to work with. …
… Another suggestion is to use forecasts of variables in the policy rule rather than actual values. If that is not done, then people say that a rule is not forward-looking because it includes current variables rather than forecasts of those variables. But the Taylor (1993a) rule, for example, was designed to deal explicitly with forward looking agents, and it is therefore forward-looking. Note that when a central bank indicates that it will predictably follow a strategy in which the interest rate reacts to the current inflation rate, it automatically says that next period’s interest rate will react to next period’s inflation rate. That’s forward-looking. Moreover, the current level of inflation and output are key factors in any forecast of inflation, and the coefficients of existing policy rules take that into account. If one replaced current inflation with a forecast of inflation, the coefficients would most likely have to be different. And the approach raises the question of whose forecast to use and how to evaluate the rule. Forecasts—including central bank forecasts—are not always that good. Also rules with forecasts of inflation and output on the right-hand side tend to be less robust …
Several years ago, I was asked to list the reasons for a rules-based approach rather than a discretionary approach to monetary policy. Though I would not characterize the list as reasons why we might want to tie central banker’s hands, they are nonetheless reasons why central banks would want to choose to run monetary policy in a rule-like fashion. Here are the reasons.
Time inconsistency. The time inconsistency problem calls for the use of a policy rule in order to reduce the chance that the monetary policymakers will change their policy after people in the private sector have taken their actions.
Clearer explanations. If a policy rule is simple, it can make explaining monetary policy decisions to the public or to students of public policy much easier. It is difficult to explain why a specific interest rate is being chosen at a specific date without reference to a method or procedure such as would be described by a policy rule. The use of a policy rule can mean a better educated public and a more effective democracy. It can help to take some of the mystique out of monetary policy.
Less short-run political pressure. A policy rule is less subject to political pressure than discretionary policy. If monetary policy appears to be run in an ad hoc rather than a systematic way, then politicians may argue that they can be just as ad hoc and interfere with monetary policy decisions. A monetary policy rule which shows how the instruments of policy must be set in a large number of circumstances is less subject to political pressure every time conditions change.
Reduction in uncertainty. Policy rules reduce uncertainty by describing future policy actions more clearly. The use of monetary policy rules by financial analysts as an aid in forecasting actual changes in the instruments would reduce uncertainty in the financial markets.
Teaching the art and science of central banking. Monetary policy rules are a good way to instruct new central bankers in the art and science of monetary policy. In fact, it is for exactly this reason that new central bankers frequently find such policy rules useful for assessing their decisions.
Greater accountability. Policy rules for the instrument settings allow for more accountability by policy-makers. Because monetary policy works with a long and variable lag, it is difficult simply to look at inflation and determine if policy-makers are doing a good job. Today’s inflation rate depends on past decisions, but today’s settings for the instruments of policy—the monetary base or the short-term nominal interest rate—depend on today’s decisions.
A useful historical benchmark. Policy rules provide a useful baseline for historical comparisons. For example, if the interest rate was at a certain level at a time in the past with similar macroeconomic conditions to those of today, then that same level would be a good baseline from which to consider today’s policy actions.
Many of these reasons would be the same if the word strategy was used rather than policy rule, and if we were referring to any other policy rather than monetary policy. It is not that we want to tie central banker’s hands as much as we want a policy that works well, and that is the case when a clear strategy is in place. George Shultz explained the importance of having a strategy. He wrote that “…it is important, based on my own experience, to have a rules-based monetary policy…. At least as I have observed from policy decisions over the years in various fields, if you have a strategy, you get somewhere. If you don’t have a strategy, you are just a tactician at large and it doesn’t add up.”
A related point is that a policy rule or strategy does not mean that that policy maker can’t do things that need to be done. Any reasonable law enforcement strategy will require actions by law enforcement officials. And sometimes not acting is violating a strategy: A decision by government financial regulators, for example, not to act when an institution takes on risk beyond the limits of the regulations is inaction and clearly poor policy. Policymakers need to explain that a policy strategy involves a series of actions.
In my view, the reasons stated here for monetary policy rules have not evolved much over the years. However, reasons against policy rules have evolved, and deserve some discussion in this assessment. They are sometimes characterized as why we should not tie central banker’s hands.
At the 2013 American Economic Association meetings, Larry Summers and I had a debate about rules versus discretion. Summers started off by saying: “John Taylor and I have, it will not surprise you…a fundamental philosophical difference, and I would put it in this way. I think about my doctor. Which would I prefer: for my doctor’s advice, to be consistently predictable, or for my doctor’s advice to be responsive to the medical condition with which I present? Me, I’d rather have a doctor who most of the time didn’t tell me to take some stuff, and every once in a while said I needed to ingest some stuff into my body in response to the particular problem that I had. That would be a doctor who’s [advice], believe me, would be less predictable.”
Thus, Summers argues in favor of relying on an all-knowing expert, a doctor who does not perceive the need for, and does not use, a set of guidelines, but who once in a while in an unpredictable way says to ingest some stuff.
But as in economics, there has been progress in medicine over the years. And much progress has been due to doctors using checklists, as described by Atul Gawande. Of course, doctors need to exercise judgement in implementing checklists, but if they start winging it or skipping steps the patients usually suffer. Experience and empirical studies show that checklist-free medicine is wrought with dangers just as rules-free, strategy-free monetary policy is.
Another recent development also appears as an argument for not wanting to tie hands. At a recent Brookings conference, Ben Bernanke argued that the Fed had been following a policy rule—including in the “too low for too long” period. But the rule that Bernanke had in mind is not a rule in the sense that I have used it in this discussion, or that many others have used it.
Rather it is a concept that all you really need for effective policy making is a goal, such as an inflation target and an employment target. In medicine, it would be the goal of a healthy patient. The rest of policymaking is doing whatever you as an expert, or you as an expert with models, thinks needs to be done with the instruments. You do not need to articulate or describe a strategy, a decision rule, or a contingency plan for the instruments. If you want to hold the interest rate well below the rule-based strategy that worked well during the Great Moderation, as the Fed did in 2003-2005, then it’s ok, if you can justify it in terms of the goal.
Bernanke and others have argued that this approach is a form of “constrained discretion”. It is an appealing term, and it may be constraining discretion in some sense, but it is not inducing or encouraging a rule as the language would have you believe. Simply having a specific numerical goal or objective function is not a rule for the instruments of policy; it is not a strategy; in my view, it ends up being all tactics. I think there is evidence that relying solely on constrained discretion has not worked for monetary policy …
… Another issue is that deviations from policy rules can be designed to be rule-like in ways that the econometrician does not know. The adjustment to the interest rate that I suggested in Taylor (2008) is an example of how a seemingly discretionary development can be incorporated into a policy rule in a systematic way. At that time, my research suggested that there was increased counterparty risk between banks, related to concerns about securities derived from sub-prime mortgages. Based on this research, I testified in Congress that, as a first line of defense, central banks should reduce their policy interest rate by the increased spread between Libor and the overnight index swap (OIS), which was about 50 basis points at the time, and then do more research to find out the reasons for the higher credit risk.
This adjustment is an example of why the Taylor rule should not be used mechanically as I emphasized that in the original Taylor rule paper (1993a), but the adjustment was meant to deal in a systematic way with a problem in the money market when the spread between Libor and OIS widened significantly. I argued that the models that were used to find the Taylor rule in the first place implied such an adjustment …
[The Sources are linked in texts above]
Also of interest:
Revisiting [Schumpeter’s] Walgreen Lectures on Institutional Innovation [2022]
Procedural Interest - a useful concept [2022]
Indiscretions of Discretionary Regulation [2012]
Evolutions of social order from the earliest humans to the present day and future machine age.