26 June 2016

The Trouble With Taylor Rules

Proponents of tight monetary policy like to show variants of the following chart
as evidence that the Federal reserve has kept interest rate too low since the financial crisis and that policy leading up to the financial crisis was too weak. To many this argument is compelling; as inflation is currently near target and output isn't too far from potential, the Federal Funds Rate should be higher, shouldn't it?

No. This analysis is flawed on multiple levels, most importantly its failure to acknowledge the nonneutrality of money. Of course no one who has shown this chart thinks that money is neutral, but they are nevertheless making a massive mistake. In reality, the interest rate implied by the Taylor Rule is affected by the actual level of interest rates. Say, for example, inflation is 2%, the output gap is zero, and the nominal interest rate is 3%. This implies an interest rate of roughly 4% in most specifications of the Taylor Rule, so the Federal Reserve raises interest rates by 1%. But now both output and inflation are lower, so the Taylor Rule suggests a lower interest rate. Thus, had the Fed raised interest rates back in 2011 when the Taylor Rule said it should have, since money is not neutral, inflation and output would have subsequently been lower, implying a lower rate suggested by the Taylor Rule.

Following a Neo-Wicksellian framework, any time inflation and/or output are above target, the interest rate either is currently or is expected to be below the natural rate. Given that both output and inflation are currently close to target, it is clear that the Wicksellian natural rate is about zero, or at least that the expected difference between all future interest rates and all future natural rates is about zero. Now is not the time to raise rates, then, as some Taylor Rules suggest.

Taylor Rules have the obvious problem of not taking the natural rate into account, or at least assuming that it is constant over time. This leads people to have mistaken expectations that interest rates should be at a certain level at full employment, not realizing that the level of interest rates determines whether or not we are at full employment; money is not neutral.

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