Taylor Rules?

John Taylor recently had a post on his blog with the accompanying graph showing the actual Fed Funds rate target of the Fed since 2005 and the Fed Funds rate implied by two versions of the Taylor rule, one that he specifically proposed and another used in a study by Janet Yellen that Taylor, in a 1999 paper, had mentioned as a possible alternative version of his rule. Taylor has subsequently tried to put some distance between himself and the alternative version, the alternative version implying a far lower optimal interest-rate target than the version that he now professes to prefer.  But while not explicitly endorsing it when first mentioning it as an alternative, neither did Taylor express any reservations about the alternative, providing no hint that he considered it to be inconsistent with the spirit of his rule or to be obviously inferior to his own previous version, for which he now insists he has a preference.

What I find especially noteworthy, aside from the remarkable fact that, as Scott Sumner noted, Taylor’s preferred rule would have called for a rate increase in early 2008, when the economy was already in recession, and on the verge of one of the sharpest one-quarter declines in real GDP on record, in the third quarter of 2008 even before the Lehman panic of September-October, is that both versions of the Taylor rule implied a target interest rate substantially higher than the Fed Funds rate actually in effect for  most of 2008. So Taylor is implicitly endorsing a far tighter monetary policy in 2008, after the economy had already entered a recession and started a rapid contraction, than the disastrously tight policy to which the economy was then being subjected by the FOMC.

Now, in fairness to Taylor, he could argue that the difficulties all stemmed from the prolonged period of very low interest rates following the 2001 recession. But that simply underscores the inherent unworkability of a mechanical rule of the type that Taylor is so enamored by. Conditions are rarely ideal, so you can never be sure that the interest rate implied by the Taylor rule (of whichever version) is preferable to the rate chosen at the discretion of the monetary authority. In retrospect, some of the time the FOMC seems to have done better than the Taylor rules, and some of the time one or both of the Taylor rules seem to have done better than the FOMC. Not exactly an overwhelmingly good performance. So why should anyone assume that adopting the Taylor rule would be an improvement, all things considered, over the exercise of discretion?

Taylor wants to argue that the exercise of discretion is bad in and of itself. But which is The Taylor rule? Taylor likes one version of the rule, but he can’t provide any argument that the Taylor rule that he prefers is better than the one that he now says that he doesn’t prefer, though no such preference was expressed when he first mentioned the alternative version. And even now, though he claims to like one version better than the other, he can only conclude his post by saying that more research on the relative merits of the rules is necessary. In other words, adopting the Taylor rule is not sufficient to eliminate policy uncertainty, as the gap in the diagram between the rates implied by the two rules clearly indicates.

The upshot of all this is just that for Taylor to suggest that adopting his rule would somehow reduce policy uncertainty when there is clearly no way to specify the parameters necessary to generate a predictable value for the interest rate target implied by the rule is simply disingenuous.  Moreover, to suggest that there is any evidence that following the Taylor rule (whatever such a vague and imprecise concept can possibly mean) would have led to better outcomes than the not very impressive performance of the FOMC is just laughable.

PS This will be my last post until next week after the Jewish New Year. My best wishes go out to all for a happy, healthy, and peaceful New Year.

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13 Responses to “Taylor Rules?”


  1. 1 Saturos September 15, 2012 at 5:00 am

    Of course Taylor is right: interest rates should have been higher in 2008. Not because the Fed was setting them higher, but rather because monetary policy was excepted to succeed, thus leading to a higher natural rate. Which of course reveals the fundamental problem with Taylor rules: the input variables are not exogenous.

  2. 2 Benjamin Cole September 16, 2012 at 4:00 am

    Great blogging of late, btw.

    Taylor is maneuvering himself to adopt a more pro-growth version of the Taylor rule, should Romney win.

    Taylor co-authored a five-page economic growth plan for Romney which does not even mention monetary policy. (!)

    http://www.docstoc.com/docs/125714335/Romney-Tax-Reform-White-Paper

    Despite the title of the above link, it is actually Romney’s economic proposals, not just his tax proposals.

    The sudden muteness on monetary policy says to me Taylor would like not to talk about monetary policy until he gets a Romney win, and then (with serious faces and and exuding an image of introducing rigor to monetary policy) introduces a “rules-based monetary policy” that is a lot like Market Monetarism.

    There is no way Taylor will want tight money that crimps the economy during a Romney term. Fuggetaboutit.

  3. 3 Saturos September 16, 2012 at 9:47 am

    You think Romney still has a chance, then, Benjamin?

  4. 4 Edward Kenney September 16, 2012 at 10:46 am

    Interesting post but I think there are political economy reasons to favor a rules based system. A rules based system MAY shield authorities from charges of politicization. Of course as Taylor makes clear, even with a rules based system, there is still potential for disagreement over output gap and other variables. Still, I think if rules based system performs at least as well as a discretionary system (not necessarily all the time), a rules based system is preferable.

  5. 5 Benjamin Cole September 16, 2012 at 6:48 pm

    Saturos:

    I live now in Thailand, so I am even one more step removed from having a feel for this election.

    Recent national elections have be so tight as to turn on suspicious voting patterns in Florida and Ohio (thanks to our antique electoral college system. Gore actually “won” the 2000 popular vote by 400,000 notes, a fact now forgotten).

    Some say new voting restrictions in key states will remove hundreds of thousands of voters from the rolls. Showing state photo ID for example.

    For me, this election is too close to call, and the Fed has acted too late to “help” Obama. One could even argue that the Fed waited as long as it could to avoid helping Obama.

    What are your views, Saturos? You make very good comments, btw.

  6. 6 John September 17, 2012 at 12:24 am

    Conditions are rarely ideal

    If so, then how can an economy tend toward equilibrium as you have argued elsewhere

  7. 7 On your Marx September 17, 2012 at 2:37 pm

    Glen Rudebusch argued for the ‘other’ Taylor rule indeed Taylor at the time was quite strident in his criticism of this approach.
    Now he isn’t.

  8. 8 Saturos September 17, 2012 at 10:50 pm

    Benjamin, I’m basically a Caplanian about politics. I think those with strong tribal affiliations will vote the way they do, and the rest will vote based on their mood at election time. The will punish the incumbent if their personal situation is worsening at that time, and/or if the latest media reporting gives them an impression of a worsening society. And vice versa if things seem to be improving at that moment. Note that this is not the same as Robin Hanson’s strategy of penalizing/rewarding presidents for the overall change in your own circumstances only (which you know most about) since the beginning of the presidential term. I think the latest job figures will show an improvement thanks to the Fed’s new move, without people having dropped out of the labor force (perhaps 0.5%). And then Obama will win.

    Besides, I believe in market forecasts. And Intrade has Romney at 67% http://www.intrade.com/v4/markets/contract/?contractId=743474
    And then there’s this:

    http://www.bloomberg.com/news/2012-09-17/today-mitt-romney-lost-the-election.html

  9. 9 Frank Restly September 20, 2012 at 10:23 am

    From Taylor’s list:

    “Stop Runaway Federal Spending And Debt. Reduce federal spending as a share of GDP to 20 percent its pre-crisis average by 2016. In so doing, reduce policy uncertainty over the need for future tax increases.”

    Taylor recognizes that the problem is the debt but he attributes the increase in the debt to the increase in spending relative to GDP (I presume he means real GDP and not that nominal stuff).

    http://research.stlouisfed.org/fred2/graph/fredgraph.pdf?&chart_type=line&graph_id=&category_id=&recession_bars=On&width=630&height=378&bgcolor=%23b3cde7&graph_bgcolor=%23ffffff&txtcolor=%23000000&ts=8&preserve_ratio=true&fo=ve&id=FGEXPND_GDPC1&transformation=lin_lin&scale=Left&range=Custom&cosd=1960-04-01&coed=2012-04-01&line_color=%230000ff&link_values=&mark_type=NONE&mw=4&line_style=Solid&lw=1&vintage_date=2012-09-20_2012-09-20&revision_date=2012-09-20_2012-09-20&mma=0&nd=_&ost=&oet=&fml=a%2Fb&fq=Quarterly&fam=avg&fgst=lin

    From the chart, from 1980 to 2000, the long term average of government expenditures to REAL GDP has been between 14% and 16% and he advocates a reduction down to only 20% – good luck getting elected on that.

    And no, Romney’s tax initiatives will not “pay for themselves”. At full employment Bush’s tax policies brought tax receipts to only 19% of GDP.

    If Mr. Romney wants to reduce spending then reduce spending. If he wants to reduce debt then sell equity instead of debt. Taylor can’t seem to separate the federal government’s financing decision from its spending decision. (Fisher’s separation theorem)

    “Reform the Nation’s Tax Code To Increase Growth And Job Creation. Reduce individual marginal income tax rates across-the-board by 20 percent, while keeping current low tax rates on dividends and capital gains. Reduce the corporate income tax rate the highest in the world to 25 percent.”

    Here again, Taylor makes the mistake in thinking that “pro-growth” tax reform revolves around tax rates. It instead revolves around tax burden.

    The ONLY way the federal government affects Real GDP growth on a non-discretionary basis (other than socialism) is by selling liabilities that have a positive real rate of return. Those liabilities become private sector assets. Both Taylor and Romney ASS-U-ME that the only way to finance the federal deficit is with debt. The corporate markets say otherwise where both debt and equity are used.

    How many bad economists cannot realize that the federal government can sell equity?

  10. 10 David Glasner September 22, 2012 at 7:22 pm

    Saturos, Yes, endogeneity is a big problem in setting interest rates. As a result, every time interest rates are set there is an ambiguity in interpreting the underlying policy. That’s an argument for some kind of nominal anchor.

    Benjamin, You have been making this argument for a long time. I hope you are right, but as Saturos points out, the odds on a Romney victory seem to be lengthening daily.

    Edward, No point in talking in generalities about rules-based systems unless we have a specific rule that we are evaluating.

    John, I think that there are certain tendencies that move an economy toward equilibrium, but there can also be tendencies moving it away from equilibrium. This is all very complicated, and hard (for me at least) to explain in a paragraph. Maybe I’ll try writing up a post about it at some unknown future time.

    On your Marx, Do you happen to have any citations?

    Saturos, You meant to say Obama at 67%. He’s now over 70%

    Frank, If you are talking about the ratio of federal spending to GDP, it doesn’t matter whether you are using nominal or real as long as both numerator and denominator are both real or are both nominal. Sorry, but I can’t make sense of your graph, because I don’t know what’s being measured.

    As a historical question, can you cite any cases in which governments have financed their deficits by selling equity? And can you explain what kind of equity instruments were used in those cases?

  11. 11 Frank Restly September 23, 2012 at 6:23 am

    “Frank, If you are talking about the ratio of federal spending to GDP, it doesn’t matter whether you are using nominal or real as long as both numerator and denominator are both real or are both nominal. Sorry, but I can’t make sense of your graph, because I don’t know what’s being measured.”

    Okay, here is nominal expenditures versus nominal GDP:

    http://research.stlouisfed.org/fred2/graph/fredgraph.pdf?&chart_type=line&graph_id=&category_id=&recession_bars=On&width=630&height=378&bgcolor=%23b3cde7&graph_bgcolor=%23ffffff&txtcolor=%23000000&ts=8&preserve_ratio=true&fo=ve&id=FGEXPND_GDP&transformation=lin_lin&scale=Left&range=Custom&cosd=1960-01-01&coed=2012-04-01&line_color=%230000ff&link_values=&mark_type=NONE&mw=4&line_style=Solid&lw=1&vintage_date=2012-09-23_2012-09-23&revision_date=2012-09-23_2012-09-23&mma=0&nd=_&ost=&oet=&fml=a%2Fb&fq=Quarterly&fam=avg&fgst=lin

    As an FYI, the Bureau of Economic analysis maintains both real and nominal measures of GDP (real being nominal adjusted by the GDP deflator). The BEA maintains nominal government expenditures only. There is no such thing as a government expenditure deflator. And so the whole concept of Real government expenditures is vague at best.

    “As a historical question, can you cite any cases in which governments have financed their deficits by selling equity? And can you explain what kind of equity instruments were used in those cases?”

    Let us define the difference between debt and equity first. Debt (as far as sovereign governments go) is a contract between borrower (government) and lender (individual, group, or company) that offers a fixed rate of return over a fixed / variable time frame. That rate of return is guaranteed by a legal protection. In the case of U. S. Treasuries – re-payment is guaranteed by the 14th amendment to the Constitution.

    Equity, on the other hand, is a contract between seller (government) and buyer (individual, group, or company) that offers a non-guaranteed rate of return.

    In essence equity claims (being non-guaranteed) are subordinate to bond holder claims (being guaranteed).

    Are there historical examples of governments selling non-guaranteed contracts? Certainly. Social Security , Medicare, Medicaid, etc. are all non-guaranteed in the sense that certain conditions must be reached for the owner of the claim to receive re-payment. For Social Security it is retirement age and maintaining a steady job during your life. If you work your entire life, contributing to Social Security all along, but fail to reach retirement age, you will not get your return on investment.

    You might argue that Social Security is an insurance policy (not equity), but on a fundamental basis, Social Security is simply a non-guaranteed claim on future tax revenue.

    Equity in the corporate realm, is an ownership claim on the profitability of a company. As such, it is a junior claim on a company’s revenue stream (bonds being senior claims). Because the federal government does not operate to turn a profit, its equity claims are not claims on profitability. It’s equity claims are instead junior claims on its revenue stream (taxes).

    You might even argue that Social Security is protected by a trust fund which would be incorrect. The Social Security trust fund is holdings of U. S. Treasuries by the Social Security Administration. The trust fund is legally protected by the Constitution through its holdings of Treasuries.

    In essence, Social Security is an equity claim on future tax revenue. The federal government sells those equity claims and uses the tax revenue to loan itself money, in the process creating additional bonds.


  1. 1 John Taylor Has Made David Glasner Unhappy | FavStocks Trackback on September 17, 2012 at 12:48 am
  2. 2 So Many QE-Bashers, So Little Time « Uneasy Money Trackback on September 21, 2012 at 10:42 am

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About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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