Fed Chair Candidate Taylor Is Woefully Misunderstood

This article appeared in The Hill (Online) on October 29, 2017.
Share

With news that the contest for Fed chair is now essentially down to frontrunner Jerome Powell and Stanford economist John B. Taylor, the latter's views have received intense criticism.

The third-degree is welcome, since candidates for important policy positions ought to be vetted thoroughly.

But in portraying Taylor as an unyielding hawk whose near mechanical insistence upon his eponymous rule would plunge the economy back into a recession, Taylor's critics aren't merely questioning Taylor's beliefs — they're torturing them.

When all of Taylor's views are considered, he does not deserve a reputation as someone dogmatically attached to a rule raising interest rates.

In a 1993 paper, Taylor introduced for a way of analyzing Fed policy that became known as the "Taylor Rule." According to the rule, the Fed could keep the economy on an even keel by adjusting its policy interest rate according to a simple formula, the main elements of which are the difference between the actual rate of inflation and the Fed's desired rate, and the gap between actual economic output and the Fed's estimate of what output would be with the economy at full employment.

When both gaps are positive, the formula calls for tightening monetary policy; when both are negative, it calls for loosening. When one gap is negative and the other positive, the bigger gap should guide policy.

The Taylor Rule seemed appealing — not just to Taylor himself, but to many economists — because it describes fairly well what the Fed had been doing, deliberately or not, during the "Great Moderation," a remarkable stretch of low inflation and subdued business cycles that ran from roughly the mid-1980s to 2007.

Even the Fed itself was impressed. Although the FOMC never followed the rule strictly — and Taylor judged that body harshly for some of its deviations — the Fed did use the Taylor Rule as a reference point in its deliberations.

This, ironically, is where much of today's criticism of Taylor comes from. If you plug recent inflation and output-gap numbers into the standard Taylor Rule, it suggests raising the policy rate much more aggressively than the Fed's present plans call for.

But this simple arithmetic neither completely represents Taylor's policy positions nor proves that as Fed chair that would only ever follow a rigid rule.

Economists Christina and David Romer, of UC Berkeley, proposed certain criteria for selecting Fed chairs, highlighting the use of a nominee's past remarks in assessing his or her candidacy. This is very useful in analyzing Taylor's actual stance on policy rules.

Before the crisis and Great Recession, Taylor was quick to caution that a rule should not and could not be implemented mechanically. Instead, a policy rule would serve as a useful guide for the Fed.

As the crisis was developing, Taylor reiterated that successfully conducting monetary policy required good judgment and that rules should be thought of as benchmarks, not mechanical instructions.

Most recently, Taylor presented a paper on the history of the monetary rules versus discretion debate at a Boston Fed conference. There, he explicitly said that rules should not be used to tie central bankers to particular decisions.

Rather, when used as guidelines, policy rules can limit the uncertainty surrounding monetary policy and improve a central bank's performance.

Taylor has been consistent, both during and after the crisis, in saying that properly designed monetary policy rules are part of an overall strategy for the central bank, and do not obligate it to specific short-term decisions.

While Taylor would likely not turn the Fed upside-down by implementing something akin to the Taylor Rule as the chair, there is one area where he might potentially lead the Fed in a new direction.

That is changing the operating framework.

Taylor has argued that he wants to see the federal funds market move from its current floor system, or sub-floor system, back to the pre-crisis model. According to that model, the Fed would adjust the quantity of reserves in the banking system and the market would set the short term interest rate. That is very different from the current regime, in which the Fed administratively sets its policy rate.

John B. Taylor has expressed a preference for the Fed returning to its pre-crisis mechanics for monetary policy. He wants to see interest rates determined by market forces. In this, he stands apart from the other candidates.

But he has been consistent throughout his career that monetary rules should serve to guide the central bank, not tie its hands. A proper evaluation of his candidacy would not ignore that fact.

Tate Lacey

Tate Lacey is a policy analyst at the Cato Institute’s Center for Monetary and Financial Alternatives.