Transcript Will the real Taylor Rule please stand up?

Will the real Taylor
Rule please stand up?
Talk with Macro students
Miami University
Michael Bryan,
Vice President and Senior Economist
Federal Reserve Act:
Language Establishing the Dual Mandate
“The Board of Governors of the Federal Reserve System
and the Federal Open Market Committee shall maintain
long run growth of the monetary and credit aggregates
commensurate with the economy's long run potential to
increase production, so as to promote effectively the
goals of maximum employment, stable prices, and
moderate long-term interest rates.”
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THE FED FUNDS RATE: THE RATE AT WHICH BANK LEND RESERVES TO EACH
OTHER OVERNIGHT. THE FOMC CONTROLS RESERVES, THEREFORE THEY
CONTROL THIS RATE.
Percent, annual rate
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THE TAYLOR RULE: Is there a simple rule that tells a central
bank like the Federal Reserve where to set the fed funds rate?
(Fed funds rate)
i
ff
= (r* +  ) + α (y-y*) + β ( -*)
Fisher equation
(defines long-run equilibrium)
The dual mandate:
1. GDP gap
2. Deviation of inflation
from price stability
What values do you assign α and β?
Taylor 1993: α = 0.5 and β = 0.5
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FOR THE MOST PART, THE FOMC (AT LEAST UP UNTIL 2003) SEEMS TO
HAVE FOLLOWED THE RULE DESCRIBED BY TAYLOR.
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Federal Funds Rate (%)
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5
4
3
2
Taylor 1993
Actual fed funds rate
1
0
-1
-2
-3
-4
-5
Mar-98
Mar-99
Mar-00
Mar-01
Mar-02
Mar-03
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AND WHEN WE DIDN’T?
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Federal Funds Rate (%)
Is the Fed getting behind the curve?
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Taylor 1993
Actual fed funds rate
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0
-1
Did this “excess monetary stimulus” create a housing
bubble and fuel the financial crisis?
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-5
Mar-98
Mar-99
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YOU PLAY POLICYMAKER. WHERE WOULD YOU SET THE FED FUNDS RATE?
HERE’S A START: THE CBO GAP ESTIMATE (BUT DON’T GET TOO ATTACHED
TO YOUR ESTIMATE—THIS ISN’T A VERY EASILY MEASURED OBJECT).
CBO Estimate of the Real Potential GDP Gap
Quarterly, as a % of Potential GDP
2%
1%
0%
-1%
-2%
-3%
-4%
1.7 = (2.25 + 2.1 ) + 0.5 (-5.4) + 0.5 (0.1)
-5%
-6%
-7%
-8%
-9%
2003
2004
2005
2006
2007
January 2012 CBO Estimate
Source: CBO
2008
2009
2010
2011
January 2011 CBO Estimate
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Some have criticized Taylors 1993 rule as being overly weighted to
inflation and not weighted enough to underperformance in the economy.
i
ff
= (r* +  )+ 0.5 (y-y*) + 0.5 ( -*)
which, with a little algebra and assuming an r* of 2
yields
i
ff
= 1 + 0.5 (y-y*) + 1.5 
After the original Taylor rules, other rules were introduced, some
putting even more weight on inflation, some more weight on the
economy. In a 1999 paper, this version of the Taylor rule emerged
that weighted the economy more heavily.
i
ff
= 2 + 1.0 (y-y*) + 1.3 
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Here is a comparison of Taylor’s 1993 rule and
the so-called Taylor 1999 rule.
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Federal Funds Rate (%)
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6
5
4
3
2
Taylor 1993
Actual fed funds rate
1
0
-1
-2
Taylor 1999
-3
-4
-5
Mar-98
Mar-99
Mar-00
Mar-01
Mar-02
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According to the Taylor 1999 rule, the FOMC should push the fed funds rate deeply
negative, which, of course is impossible. For all practical purposes the fed funds rate
can not go below zero. This is called a “zero nominal bound” on interest rates.
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Federal Funds Rate (%)
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6
5
4
3
2
Taylor 1993
Actual fed funds rate
1
0
-1
-2
Taylor 1999
-3
-4
-5
Mar-98
Mar-99
Mar-00
Mar-01
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So how is monetary policy conducted at the zero nominal bound? How does the FOMC
conduct a policy that has the same impact as a negative fed funds rate? Quantitative
easing—we expand our balance sheet so as to “mimic” a negative fed funds rate.
Start of QE1
Start of QE2
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Still other Taylor rules have been proposed and a discussed in FOMC deliberations.
Some of these rules allow for “inertial” fed funds rate adjustments, others use
forecast values rather than current values for inflation and output.
Percent
4.0
3.5
3.0
2.5
2.0
Taylor 1993
(Puts equal weight on slack and inflation)
1.5
Outcome based
1.0
0.5
0.0
Taylor 1999
(Puts more weight on slack)
-0.5
Jun-10
Dec-10
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Note: Taylor rules are based on August 2011 CBO estimate of potential output.
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How long will the FOMC be faced with a zero nominal bound? When will
interest rates begin to rise again?
Percent, annual rate
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2014?
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Different rules, different forward guidance. Not everyone on the FOMC
necessarily uses a Taylor-rule in deciding their preferred path for monetary
policy. And those that do, use it with varying degree of faithfulness.
“In particular, the Committee decided to keep the target range for the federal
funds rate at 0 to 1/4 percent and currently anticipates that economic
conditions…are likely to warrant exceptionally low levels for the federal funds
rate at least through late 2014.”
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Will the real Taylor
Rule please stand up?
Talk with Macro students
Miami University
Michael Bryan,
Vice President and Senior Economist