Paul Krugman picks up on my post about proposed legislation to get the Fed to pick a policy rule. The legislation is being championed by John Taylor because he thinks that the reason we got into this mess was because we deviated from his rule.
It’s interesting to wonder whether in fact the truth is the reverse.
Was it the sticking to the rule, rather than deviating it, which got the Fed trapped at the zero bound? That’s one way of reading PK’s post.
In the public exchange between JT and Bernanke, Bernanke argued that they didn’t really deviate from the rule, so that could not have been the problem. However, PK – if he is suggesting this – has theory on his side in the shape of a paper by Schmitt-Grohe and Uribe called ‘The perils of Taylor Rules‘. This paper shows that religious adherence to the Taylor Rule produces two ‘steady-states’ [jargon for where the economy settles when there is nothing buffeting it around], one of which involves interest rates trapped at the zero bound.
I don’t really think this can be the reason. The theory offers a knife-edge result, a trap that would be avoided by a Fed with even a slight tendency for discretion. And those who are briefing FOMC and even on it don’t use rules like this. Though many of them produced the papers exploring the usefulness of these rules, their instinct is to respond as they sit to events as they arise.
In so far as monetary policy was at fault, the problem was that it was directed at a rate of inflation that with hindsight was just too low. Hence why I and others, PK and Blanchard included, have argued for a higher inflation target in the future. In the long run, higher inflation means higher central bank rates, one for one. And this means fewer and less severe episodes at the zero bound.
Sumner points out that a higher inflation target means a smaller Fed balance sheet, because higher inflation expectation reduces demand for money and increases velocity, meaning a smaller monetary base gives you the desired level of NGDP.
We would do better with a higher inflation target. Better still with a price level-path target. Better still with a NGDP level-path target. There is so much opportunity to improve monetary policy, what an exciting time.
Menlo Park, CA
“In the long run, higher inflation means higher central bank rates”.
Wouldnt you need lower rates to generate higher inflation? Long rates would be higher but short rates would be lower under a higher inflation targeting regime.
No. Check out, eg Walsh’s textbook, which explains Fisher effect, how this holds in the data and in standard monetary models.