Monetary Policy: Bernanke and Yellen v. Taylor

The economist bloggers should all rejoice the fact that Ben Bernanke has joined us. His first post is excellent and I will present a key quote shortly. But let me express my main frustration with how some people are using the Taylor rule versus something that Janet Yellen recently noted:

Even with core inflation running below the Committee’s 2 percent objective, Taylor’s rule now calls for the federal funds rate to be well above zero if the unemployment rate is currently judged to be close to its normal longer-run level and the “normal” level of the real federal funds rate is currently close to its historical average. But the prescription offered by the Taylor rule changes significantly if one instead assumes, as I do, that appreciable slack still remains in the labor market, and that the economy’s equilibrium real federal funds rate–that is, the real rate consistent with the economy achieving maximum employment and price stability over the medium term–is currently quite low by historical standards. Under assumptions that I consider more realistic under present circumstances, the same rules call for the federal funds rate to be close to zero

Taylor has been arguing for some time that monetary policy is keeping interest rates too low for too long. OK, if one believes were are near full employment and one believes that Wicksellian natural interest rate is still 2 percent, this follows. But many of us – including Yellen - reject both premises. What is Taylor’s response?

So the main argument is that if one replaces the equilibrium federal funds rate of 2% in the Taylor rule with 0%, then the recommended setting for the funds rate declines by two percentage points. The additional slack due to a lower natural rate of unemployment is much less important. But little or no rationale is given for slashing the equilibrium interest rate from 2% percent to 0%. She simply says “some statistical models suggest” it. In my view, there is little evidence supporting it, but this is a huge controversial issue, deserving a lot of explanation and research which I hope the Fed is doing or planning to do.

Might I suggest Taylor start his research by reading Bernanke’s first blog post:

Low interest rates are not a short-term aberration, but part of a long-term trend ... The real interest rate is most relevant for capital investment decisions, for example. The Fed’s ability to affect real rates of return, especially longer-term real rates, is transitory and limited. Except in the short run, real interest rates are determined by a wide range of economic factors, including prospects for economic growth—not by the Fed. To understand why this is so, it helps to introduce the concept of the equilibrium real interest rate (sometimes called the Wicksellian interest rate, after the late-nineteenth- and early twentieth-century Swedish economist Knut Wicksell). The equilibrium interest rate is the real interest rate consistent with full employment of labor and capital resources, perhaps after some period of adjustment. Many factors affect the equilibrium rate, which can and does change over time. In a rapidly growing, dynamic economy, we would expect the equilibrium interest rate to be high, all else equal, reflecting the high prospective return on capital investments. In a slowly growing or recessionary economy, the equilibrium real rate is likely to be low, since investment opportunities are limited and relatively unprofitable. Government spending and taxation policies also affect the equilibrium real rate: Large deficits will tend to increase the equilibrium real rate (again, all else equal), because government borrowing diverts savings away from private investment.

The converse is true as the unwise fiscal austerity evidenced both in the U.S. and Europe is driving down the Wicksellian natural rate. Has John Taylor not been paying attention to the real world over the past several years? Fortunately for us, Ben Bernanke and Janet Yellen have been.