John Taylor talk on Monetary Policy

What should an educated person know understand what the Federal Reserve (Fed) is actually doing and trying to do? Main mission: keep the purchasing power of the dollar stable, prevent inflation, make sure we don't have a Great Depression again or high inflation as in the 1970s, mainly by keeping inflation low. Set up in 1914. Keep price level stable and avoid catastrophe like the Great Depression. Newspaper business sections would seem to think the job of the Fed is to steer the economy, stimulate it but not too much. Goal of price stability is consistent with keeping the economy stable. Can see that historically, macroeconomic models or just common sense. Late 1960s, early 1970s, inflation got into double digits, Fed would put on the brakes, boom and bust. Roughly 5 recessions, one every three or four years. Look at years started in the early 1980s, Volker followed by Greenspan, lower and steadier inflation rate. Had a huge reduction in the volatility of GDP; since 1982 only 2 recessions in a span of 25 years, and both very mild. Newspaper says you can either have price stability or growth. Very short term. Need long term perspective. Short term seems to have this trade-off, but it's a false tradeoff.

To keep inflation down you have to keep the growth of the money supply down, but the way the Fed talks about its policy is through interest rate changes. Average person has the following story in mind: When the economy is slowing, the Fed needs to cut interest rates to stimulate the economy, and that in turn should stimulate monetary expansion, encouraging more borrowing, which in turn should raise prices. What is right way to think about what the Fed says in talking about interest rates? If you want to control inflation, control the money supply, more money causes higher prices. That is a fundamental aspect of monetary theory. But measuring money has become more difficult because of all the different ways people can pay for things, AMTs, credit cards, savings. What has happened is the use of the interest rate rather than money to control inflation. Now when they meet they debate what the Federal Funds rate should be. [Recorded Aug. 4, 2008.] Federal Funds rate is the rate that banks charge each other when they borrow overnight. Currently 2%, average; market rate, banks can charge anything they want. Fed affects it not by setting it directly but by supplying more or less funds to the market. If they withdraw funds from the market it makes money tighter and raises the Federal Funds rate. Same idea as if you were trying to affect the price of corn: supply more corn drives the price of corn down. What's the Fed doing? It's got to buy something. They could in fact buy ketchup. But what they do buy is Treasury Bills. If they want to raise the rate from 2% to 2.25%, they sell T-Bills and extract money from the economy. They watch the rate, not trying to pinpoint it exactly but try to keep it roughly around their target.

At a time when they are injecting money into the economy and cutting the Federal Funds rate rate, why isn't that inflationary? Why won't that lead to a conflict between the stable price level and the healthy economy? Can be inflationary if overdone. Question is: how much? Benchmarks. Does require judgment. What they want to do is lower interest rates if inflation seems to be falling; if inflation starts to rise they should be raising interest rates, putting money out of the system. Want an even keel of price stability. Taylor Rule; distinction between what the Fed should do and what it actually does. What is the Taylor Rule? Both a guide and a description, both normative and positive. In the 1980s when Fed was moving away from money to interest rates as a guideline. Researchers were trying to build on the work of Milton Friedman, who emphasized transparency, policy rule for the money supply. Economists wanted to try to replace that rule with a guideline for the interest rate, normative, what the Fed "should" do. Taylor Rule: Fed should look at inflation and also state of the economy, GDP. If inflation rises by say 1 percentage point, Rule says the Fed should increase the interest rate by 1.5 percentage points. Important that the change should be larger than the change in the interest rate to get enough of a response by the system to bring inflation rate down. If GDP starts to fall, say by 1 percentage point from its growth page, Rule entails cutting the interest rate by ½ a percentage point. There the coefficient is .5, arrived at by trying different rules out within the model. And we had some natural experiments in history. Simulation within models, came up with Rule in the late 1980s, early 1990s. Soon after publishing that work, 1992, Federal Reserve policy turned out to be very closely described by that Rule; that it, it was a positive description, what actually was done. Throughout most of the 1990s till recently, closely describes Fed, though sometimes off. If you go back to the bad old days of the late 1960s and early 1970s, the Fed could not be described by this simple policy rule, and economy was doing poorly. Same story holds for many other countries. If they follow the Rule things are pretty good and if they don't follow the Rule things are pretty awful.

One response: 25 years is a small drop in the bucket, maybe just random correlations. Is it more than just a coincidence? Nothing lasts forever, financial system or technology could change. Discussions frequently happen as to whether the Fed should engage in different policies. Happens sometimes. Looking back at 2000-2004, Fed had a rate lower than predicted by the Rule; now we have a crisis, which again suggests that going off the Rule was not a good idea. Emerging market countries, worried about exchange rates, Central Banks are getting off the Rule, maybe because exchange rates are becoming more of a factor. Glass half-full aspect: it's working. Benchmark, not meant to be mechanical, need to have people making judgments. But when you've seen deviations it's led to events we'd rather not have. 1987, stock market crash; 1998, Fed went under what was predicted by the Rule, ultimately required tightening the monetary policy; recession, though after revisions it was not a recession because there weren't two consecutive quarters of GDP growth decline. Labor markets acted like they were in a recession, similar to current situation: GDP growing but jobs declining. Surprising how long it took the labor market to look like it was a healthy economy. We've had 25, even 50 good years though the 1960s and 1970s weren't great. Is that true relative to the 19th century when we didn't have a Federal Reserve? And: how ought we structure the Fed and maybe chastise the Chair down the road if the Rule is not followed? Look back, Great Depression was terrible performance, double-digit, 25% unemployment rate, Friedman and Anna Schwartz, Fed didn't keep money growth up, can blame the Fed. In last 25 years we've avoided those kinds of catastrophes, under the leadership of very skilled people, Volker, Greenspan, really tremendous. How can you prevent people from doing the wrong thing fo political reasons? True of all kinds of public policy, have vested interests, earmarks, corrupt officials. We can rely on our democracy to get the best people whether it's tax policy or monetary policy, recordings like this podcast so people can debate these policies. Giving some independence to the leadership so they are not tied to political policy; though that can go the wrong way.

Artfulness of the job; might we not have been better off if we had implemented Milton Friedman's steady rule, say, mechanically run by a computer? Didn't go very far politically. Disadvantages of deviating. Deviation of 2002-2003 period; if they deviate again it will get them back on track. Friedman podcast: they talk about it but they really follow a steady money growth rule. What he's saying here: Take the Taylor Rule, increase interest rates when inflation rises, so you are really pulling back on the money supply, like keeping the money growth rate constant. Good sign of robustness of the Taylor Rule is that it has features like a fixed money growth rule. With a fixed money growth rule if inflation picks up then real money balances decline, amount of money compared to prices, purchasing power of money, which automatically causes interest rates to rise. Magnitudes might not be the same as with Taylor Rule, but similar results. But a fixed money growth rule is not how Central Banks think about it.

Risks currently in place in our economic system. Barro, disasters, still low but increased risk now. Economy grew last quarter, though not as much as we'd like; job growth is negative but relatively small compared to past downturns. But people wave around frightening scenarios. Under the surface, some unusual happenings that would make anyone worry. Look at financial system, at 3-month bank lending to each other, unusually high. Suggests banks are worried about lending to each other, unusual risk factor. Due to the fact that there are unusual securities out there, mortgage obligations that people don't know how to assess their value. If housing prices continue to fall, those securities will seem even more suspect. But how will that spread to the rest of the economy? So far, though economy is weak, it could be worse. Three players in the financial market situation: Fed and Treasury have both acted unusually. Bear Stearns, Freddie Mac, and Fannie Mae. Couldn't let them fail, Fed orchestrated rescue of Bear Stearns, forcing it into a salvage operation; about to bail out Freddie Mac and Fannie Mae. If Bear Stearns made poor decisions, shouldn't it just go out of business, creditors should have paid the full price? What was Fed worried about? Hard to assess from the outside, spillover. Creditors would get stuck with the collateral of Bear Stearns's loans. Some of those creditors were mutual funds, money market mutual funds; they would be obligated to sell that, could put money market mutual funds at risk. Moral hazard, encouraging people to take risk. Have to find a way to clarify what will happen in the future. What about a hedge fund? Crucial for the Fed, Treasury, and Government to clarify. Public officials have not yet articulated it. Guidelines: when will an intervention like that take place. Reporting system, so when you do intervene there is a follow-up report. People who made these bad decisions have to have better accountability in the financial systems.

Head of Bear Stearns lost about $100 million, pretty high price, pretty accountable. Subprime, people bundle a lot of junk together and sold it to someone who was expected to sell it to someone else. A smart person, any person should realize that prices could come down. A lot of people who took the risks are accountable, losing their houses, money. Some of the interventions have reduced accountability. People who lent money to Bear Stearns were bailed out. They made unwise decisions but they are being left alone. Danger here is that by trying to prevent the spillovers you reduce the effective risk people are holding which results in more risk. Financial sector does have spillovers. Liquidity in the U.S. system. Good in general that institutions lend to each other but not good if you don't look too closely. Value of all the financial instruments is tremendous but the complexity creates more risk. Transparency; rating agencies did a terrible job. Possible to limit spillover to people who were not involved in taking the risks. High leverage ratios, market place should do a good job to limit that risk without bailouts, but with bailouts it encourages people to take more risks, run into the spillover problem all over again. And people blame it on the markets. Step back, look at the whole deal, can't help but be optimistic about the future. Low risk, whole world has capitalism and markets spreading, billions of people coming from poverty to the middle class. What's happened in China could happen in Africa. Will look back on current experience as a learning experience.

Sudesh Kumar
London, UK


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