Sunday, September 2, 2007

John Taylor Takes the Fed to Task for Its Past Monetary Profligacy

During my brief stint at Treasury John Taylor was my boss. Between 2001 and 2005 he was the undersecretary for international affairs at Treasury . Like Ben Bernanke, John Taylor is also a macro/monetary all-star economist and so it was a real opportunity for me to work for him at Treasury. He has had his critics, but I always found him to be gracious, kind, and a hard worker. I suspect some of the challenges he faced were the creation of the White House and would have played out regardless of who was at the helm of international affairs at Treasury (see his side of the story). In any event, he made a speech at the Jackson Hole symposium this weekend that was on the money: he called the Fed to task for its past monetary profligay (also see this post)! Greg Ip of the Wall Stree Journal tells us more:

Stanford University economist John Taylor, author of the famous “Taylor rule,” joined that growing chorus of critics in his own remarks at Jackson Hole. The Taylor rule tells the Fed how to set interest rates based on how far inflation is from its target, how far unemployment is from its natural level, and the long-run “neutral” interest rate.

Using an econometric model, Mr. Taylor says the Taylor rule would have told the Fed to raise the federal funds rate from 1.75 % in 2001 to 5.25% by mid-2005. Housing starts, around 1.6 million in 2001, would have peaked at 1.8 million (annual rate) in early 2004 then begun a gentle decline. In reality, the Fed cut the rate to 1% in 2003, then began raising it in 2004, only reaching 5.25% in mid-2006. Housing starts soared to 2.1 million by early last year and have since plummeted, to around 1.5 million. “A higher funds path would have avoided much of the housing boom … The reversal of the boom and thereby the resulting market turmoil would not have been as sharp,” Mr. Taylor said.

Mr. Taylor acknowledges the Fed had good reasons to err on the side of easy policy and that low long-term interest rates also boosted housing. But he argues long-term rates were low in part because investors may have seen the Fed’s easy policy as evidence of a permanent de-emphasis of inflation, making long term rates less responsive to the Fed. The lesson, he says, is that when the Fed departs from business-as-usual, as risk management caused it to do in 2002-2004, it can be “difficult for market participants to deal with and lead to surprising changes in the economy.”


Update

JMK
in the comments section asks a follow-up question to John Taylor's remarks:

"If the Fed was perceived to be less inflation-averse, wouldn't that lead to higher long-term rates, according to Fisher theory of nominal rates... ?"

My understanding is that John Taylor is invoking the expectation theory of interest rates--long term rates are the average of expected short term rates--to explain why long term rates were unusually low during the period in question. He is arguing that the Fed's incredibly lax monetary policy between 2002 and 2005 may have been interpreted by the market as meaning the Fed is permanently less inflation averse than it was before. Consequently, in the future the Fed would be less likely to respond to inflationary pressures and increase its short term policy rate. Given the expectation theory, this change would also mean long term interest rates would be less likely to go up as much either.

John Taylor's speech can be found here.

2 comments:

  1. ....But he argues long-term rates were low in part because investors may have seen the Fed’s easy policy as evidence of a permanent de-emphasis of inflation, making long term rates less responsive to the Fed.

    If the Fed was perceived to be less inflation-averse, wouldn't that lead to higher long-term rates, according to Fisher theory of nominal rates + expectations theory of term structure?

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  2. Good quesitn JMK. I have posted your question and my preliminary answer above in an update to the posting.

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