Thursday, April 16, 2015

Yellen and Taylor on the Taylor Rule

 In her last speech, Janet Yellen argued that:
"For example, the Taylor rule is Rt = RR* + πt + 0.5(πt -2) + 0.5Yt, where R denotes the federal funds rate, RR* is the estimated value of the equilibrium real rate, π is the current inflation rate (usually measured using a core consumer price index), and Y is the output gap. The latter can be approximated using Okun’s law, Yt = -2 (Ut – U*), where U is the unemployment rate and U* is the natural rate of unemployment. If RR* is assumed to equal 2 percent (roughly the average historical value of the real federal funds rate) and U* is assumed to equal 5-1/2 percent, then the Taylor rule would call for the nominal funds rate to be set a bit below 3 percent currently, given that core PCE inflation is now running close to 1-1/4 percent and the unemployment rate is 5.5 percent. But if RR* is instead assumed to equal 0 percent currently (as some statistical models suggest) and U* is assumed to equal 5 percent (an estimate in line with many FOMC participants’ SEP projections), then the rule’s current prescription is less than 1/2 percent."
The point is clear, given the uncertainty about what the natural rate of unemployment and the equilibrium or natural rate of interest actually are, then there is some space for keeping the Fed Funds rate close to zero, where it is.

John B. Taylor cited the passage above to criticize Yellen's view. He said:
"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."
Taylor is okay with not having a clue about the natural rate of unemployment (tells you something about a theory that depends on a variable they never know where it is), but seems to think that the natural rate of interest is really 2%. I haven't seen the empirical analysis that shows that the natural rate of interest is 2%.

Frankly, if the methodology is the same as used for the natural rate of unemployment, meaning some average of the actual rates, I'd be somewhat underwhelmed. And I'm not even going to discuss the logical problems of the natural rate of unemployment (yes, there is no such thing). But if Taylor were right, we should have inflation around the corner. He has been complaining about the Fed policy for a while, and inflation hawks have suggested that hyperinflation would follow Fed expansionary policy for six years now. The question is when would Taylor and the inflation hawks be satisfied that inflation is not accelerating? The answer is probably never. The new Taylor rule should be hike the rate of interest in every circumstance then.

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