John Taylor defends a troublesome target

[This is quite “ancient”, first published on September 18, 2011, but I believe still has relevance]

Writing for Bloomberg, John Taylor goes all in for the Fed concentrating exclusively on “price stability” (meaning 2% inflation target):

…By contrast, for most of the 1980s and 1990s — starting when Paul Volcker became chairman — the Fed stressed the goal of price stability in its actions. The result was much lower unemployment than before or since.

The dual mandate language is based on an outmoded concept of a tradeoff between inflation and unemployment. Moreover, too many goals blur responsibility and accountability. The dual goal enables politicians to lean on the Fed, and people often cite it as an excuse for unconventional policies.

Indeed, one of the reasons for the growing interest in removing the dual mandate is the extraordinary discretionary actions the Fed has taken in the past few years — including large-scale purchases of mortgage-backed securities and longer-term Treasuries, a strategy commonly called “quantitative easing.”

The Fed has explicitly used the dual mandate to justify these unusual interventions. During the 1980s and 1990s, Fed officials rarely referred to the dual mandate (even in the early 1980s, with unemployment rates as high as today). When they did so, it was to make the point that achieving price stability was the surest way for monetary policy to keep unemployment down.

In his Monetary Policy and the Long Boom published in the St Louis Fed Economic Review in 1998, Taylor was one of the first to “identify” what came to be known as the “Great Moderation”. The main reason according to him: “More aggressive response of the FF rate to changes in inflation”. And he shows the following figure (which has become a staple in textbooks) that reflects the “Taylor Principle”:

When the members of the FOMC make decisions about the interest rate— whether back in the 1970s or today—they look at a number of factors, including the inflation rate and real GDP.

Is it possible to see a change in this decision-making process that could explain The Long Boom? Has anything important changed about monetary policy? To explore these questions, consider a numerical example that illustrates how the FOMC might respond to a change in the economy, such as an increase in the inflation rate. First, imagine that the FOMC gets reports that the inflation rate is 1 percentage point higher. Let us suppose that in this circumstance the

FOMC decides to raise the federal funds rate by .75 percentage points. The inflation rate is up by 1 percentage point, and the interest rate is up by three-quarters of a percentage point. The FOMC has raised the interest rate in response to inflation.

But what happened to the difference between the federal funds rate and the inflation rate, a measure of the real interest rate? According to this measure, the real interest rate has gone down by a quarter of a percentage point. In other words, the federal funds rate did not go up by enough to raise the real interest rate. It is the real interest rate that affects spending.

So by allowing the real interest rate to fall, the FOMC would be doing exactly the opposite of what it should do when the inflation rate rises. The FOMC members would be voting to stimulate the economy just when they should be trying to cool off an inflationary surge. So this policy, with a response of .75 percentage points, is not a good policy. It adds fuel to the inflation fire.

It´s not surprising to learn that according to Taylor the “bad” MP in 2002 – 2004 – where by “bad” he means that Fed policy, by not following the “Taylor Principle”, kept interest rates “too low for too long” – bears responsibility for the house bubble and, therefore, is an important “cause” of the crisis.

Sixteen years ago (30 years ago from today) I wrote a paper: “Are_analysts_missing_the_point“; that inter alia tried to probe explanations for the increased economic stability since the early 1980´s.

A surprising result was to discover, contrary to the idea mentioned in Taylor´s “The Long Boom, that after 1983 the Fed reacted more strongly to inflation, that in fact the opposite is evidenced, with the FF rate showing no significant response to inflation.

The figures below, which show the impulse response functions from a VAR between the FF, inflation and unemployment, indicate that after 1983 monetary policy did not react significantly, either to inflation or unemployment. Although not significant, the response to inflation has the wrong sign!

One plausible explanation for the result that reconciles the (apparently contradictory) absence of response of the federal funds rate to inflation after 1982 with a postulated increase in the Fed.’s resolve to fight inflation is that the behavior of inflation changed after the 80/82 recession.

In fact, inflation after 1982 exhibits substantially less persistence than in the previous years (see figure below) so that increases in inflation in one month are viewed as temporary.

In other words, inflation is much less auto correlated so that lagged values of inflation provide little information about future inflation. As a result, unexpected movements (or innovations) in inflation no longer require a monetary policy response (which sits well with the argument that the fed funds can be a poor indicator of monetary policy).

This leads me to think that “inflation targeting” as the sole mandate for the Fed may not be a good idea. What propels the economy is nominal (or dollar) spending, so to achieve economic stability we should be concerned with “spending stability” along a level target path.

It appears that the “Great Moderation” came about exactly because, even if unwittingly, Greenspan managed for the most part to keep spending pretty stable along a determined path.

The two pictures below tell a compelling story. The first indicates that a “Great Moderation” is possible to achieve and “perpetuate”, even if the talk is always about the “inflation fighting credentials” of the Central Bank.

The ultimate cause is the maintenance of “monetary equilibrium”, which requires that changes in money demand (velocity) are offset with changes in the stock of money, which, from the equation of exchange: MV=Py, is equivalent to keeping nominal spending (NGDP) stable. In this case, inflation expectations are well anchored.

The second figure shows that during the period of the “Great Inflation”, from around 1965 to 1979, inflation expectations weren´t anchored so that growth in nominal expenditures was mostly reflected in changes in inflation.

Real growth was very volatile. The oil price (supply) shock, which increases inflation and reduces real growth, is clearly visible inn 1974/75. To Arthur Burns, there was nothing monetary policy could do and nominal expenditures were increased to reduce unemployment, with inflation control being the province of “incomes policy”. The result: more inflation.

One of the dangers associated with the absolute pursuit of “price stability” is the occurrence of supply shocks. This quote is from a Bernanke and Getler paper (my bold):

Macroeconomic shocks such as oil price increases induce a systematic (endogenous) response of monetary policy. We develop a VAR-based technique for decomposing the total economic effects of a given exogenous shock into the portion attributable directly to the shock and the part arising from the policy response to the shock.

Although the standard errors are large, in our application, we find that a substantial part of the recessionary impact of an oil price shock results from the endogenous tightening of monetary policy rather than from the increase in oil prices per se.

Symmetrically, in the case of a positive supply (productivity) shock, a substantial part of the expansionary impact of the shock would result from the endogenous easing of monetary policy.

In both cases the unwavering pursuit of price stability would be destabilizing!

According to the views of Market Monetarists, since a nominal GDP target ignores aggregate supply shocks it dominates an inflation target. It sees movements in the price level as a symptom of whatever underlying shock is taking place while regarding movements in nominal spending as an underlying shock itself – an aggregate demand shock – over which the Fed has direct influence and can respond to much more effectively.

In essence, by not reacting to the “symptoms” and striving to keep AD stable, Fed policy would result in overall stabilization.

What´s interesting about Bernanke is that he seems to know all the dangers associated with inflation targeting. The quote above is one example. He also seems to know all about how to get an economy out of the “hole” it can fall in when monetary policy errs dramatically. This is evident in his now (in)famous 1999 paper “Japanese Monetary Policy – a case of self-induced paralysis”?

Yet he managed to make both errors. First by reacting strongly to the oil/commodity price shocks of 2007/08, he managed to throw an already frail economy into a “deep hole”.

Second, by adhering to his “Creditist” views, all the while maintaining concern with the “inflation target”, he has been incapable of giving the necessary uplift to the economy.

Naturally, the “Fiscalists” came forth in defense of “fiscal stimulus”. That didn´t work, with the end result being that after more than two years of a so called “recovery”, the only possible solution seems to be found in overall austerity – both fiscal AND monetary!

So no Professor Taylor, the proper single mandate should be “Spending Stability”, i.e. targeting NGDP-Level target.