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Saturday, July 25, 2009

The Taylor Rule Debate

by Calculated Risk on 7/25/2009 09:11:00 AM

From Bloomberg: Taylor Says Fed Gets Rule Right, Goldman Doesn’t

Economists from Goldman Sachs Group Inc., Macroeconomic Advisers LLC, Deutsche Bank Securities Inc. and even the San Francisco Federal Reserve Bank argue the Taylor Rule, a pointer for finding the correct level for interest rates, suggests the Fed should be doing a lot more to stimulate the economy.

Taylor said his measure shows just the opposite: that Fed policy is appropriate, that central bankers are right to be considering how to withdraw their unprecedented monetary stimulus and that critics who say otherwise are misinterpreting his rule. The formula is designed to show the best rate for spurring growth without stoking inflation.

“They say they’re using the Taylor Rule, but they’re not,” Taylor, an economist at Stanford University in Stanford, California, said in an interview. “My rule does suggest a long time before we raise rates. But it also does suggest an earlier rate increase than you would think.”
And from Goldman's Hatzius (June 2nd, no link):
[S]everal highly respected voices have weighed in on this debate, with arguments that imply a smaller need for Fed balance sheet expansion than suggested by our calculations. The first challenge came from Professor John Taylor—father of the eponymous rule—at an Atlanta Fed conference (see “Systemic Risk and the Role of Government,” May 12, 2009). Taylor argued that his rule implies a fed funds rate of +0.5%. He specifically attacked a reported Fed staff estimate of an “optimal” Taylor rate of -5% as having "... both the sign and the decimal point wrong.”

What’s going on? The answer can be seen in a note published by Glenn Rudebusch of the San Francisco Fed [in May]; it justifies the Fed’s -5% figure and reads like a direct reaction to Taylor’s criticism, even though it does not reference his speech (see “The Fed’s Monetary Policy Response to the Current Crisis,” FRBSF Economic Letter 2009-17, May 22, 2009). The difference is fully explained by two choices. First, Taylor uses his “original” rule with an assumed (but not econometrically estimated) coefficient of 0.5 on both the output gap and the inflation gap, while the Fed uses an estimated rule with a bigger coefficient on the output gap. Second, Taylor uses current values for both gaps, while the Fed’s estimate of a -5% rate refers to a projection for the end of 2009, assuming a further rise in the output gap and a decline in core inflation.
Back in May, using then current data, Professor Taylor argued his rule implied a fed funds rate of plus 0.5 percent. Now Dr. Taylor argues current data suggest a rate of negative 0.955 percent.

Rudebusch uses a much larger coefficient for the output gap, and his method - with 9.5% unemployment - would suggest a -5.0% Fed Funds Rate currently. Since his method is also forward looking and assumes a higher unemployment rate later this year (very likely) Rudebusch approach suggests an even lower Fed Funds rate.

For the Fed Funds rate, with a zero bound, this debate doesn't matter right now - but it will matter in the future. But the debate does matter now for the Fed's other policies, as noted in the Bloomberg article:
Since the Fed can’t lower rates to less than zero, the Taylor rule means the central bank has to pump money into the economy through other methods, such as purchases of Treasuries, mortgage securities and agency bonds.
Taylor argues the Fed doesn't need to use these other methods - at least not much - Rudebusch would argue these other methods are needed.

Note: Here is a spreadsheet for Rudebusch's Taylor rule method.