Steve Williamson responds to my post asking whether it was sticking to the Taylor Rule that got us into the mess [the opposite of John Taylor’s contention, that it was departing from it that was the problem!].
Two points by way of a response.
My first arises, I think, out of a misunderstanding Steve has of my ambiguous drafting. In my post I explain the result than in the NK models religious adherence to the Taylor Rule produces two steady-states, one involving being trapped at the zero bound. I argue that this wasn’t the reason the Fed wound up trapped at the zero bound, because those at the Fed ‘don’t use rules like this’. By which I mean ‘don’t use rules in the sense of believing them to be religiously adhered to’ and not ‘don’t use Taylor Rules for any purpose’ which Steve takes that to mean. Monetary policy rules are ubiquitous in conversations about monetary policy in the Fed and all central banks. But talking about them is not enough. SGU’s paper doesn’t have anything to say about central banks that follow a Taylor Rule unless they think it’s leading them into a liquidity trap and then deviate from it. Or about central banks that use Taylor Rules as a ‘cross check’ [a frequently used term that in my experience meant not really using them at all].
The point being that without total commitment to the rule, this pathology of the model goes away.
Steve’s second point is a reprise of his contentions in previous blogs that the Fed could raise inflation by raising the nominal interest rate. And, relatedly, that perhaps inflation is too low because the Fed lowered rates.
This has been debated on the blogosphere extensively. I don’t have anything new to add to it. A summary of the case against Steve is something like this:
1. Steve’s proposition is true in flex-price versions of the standard monetary business cycle model. But in that model, business cycles are of no concern, and the Fed would have no business attempting to smooth them, or doing anything with interest rates. Rather, interest rates at zero forever is Nirvana, this being the Friedman Rule which equalises returns from holding monetary and real assets.
2. Micro evidence suggests – though there are a few who dispute it – that prices are sticky. In the sticky price version of the model in 1. above, Steve’s contention is not true. Raising nominal rates would raise real rates and depress demand, lower inflation, raising real rates, accentuating that recession, and so on. Steve and his peers in the ‘new monetarist’ literature often say: so what? This model is full of made up stuff that can’t be justified from first principles. I’m in the camp that worries about this and much admires what Steve and coauthors are doing to construct alternative and ‘deeper’ macro-models. But for now, the conventional model seems to be the best we have.
3. Empirical VAR evidence on the effects of identified monetary policy (ie interest rate) shocks suggests that raising rates would have effects similar to those described in 2. Taken individually, there are lots of shots one can take at papers in this literature. But taken as a whole, the evidence is pretty compelling. If you raise interest rates, inflation falls. Some (like Uhlig, for example) quibble about whether output falls. Most don’t.