What's Wrong with the Taylor Rule?
Economists have long debated whether rules or discretion should govern monetary policy. But after inflation declined in the 1980s, the debate partly subsided as many began to favor what are called “feedback rules.” With strict rules seen as too rigid and unconstrained discretion as too flexible, feedback rules allegedly provided the best of both worlds. And the premier feedback rule is the Taylor Rule. Indeed, many critics of the Federal Reserve, believing that it had exercised far too much discretion either prior to or in response to the financial crisis of 2007-2008, conclude that it should have adhered more closely to the Taylor Rule. Some have now gone so far as to propose legally binding the Fed to this kind of feedback rule. Yet a closer look at the Taylor Rule reveals that it is fundamentally flawed and could well make monetary policy worse.
This is the opening paragraph of “What’s Wrong with the Taylor Rule?” by San Jose State University economics professor Jeffrey Rogers Hummel. It’s one of the two Featured Articles for November’s Econlib.
Here’s one of my favorite paragraphs:
Although economists disagree about the magnitude, extent, and duration of the liquidity effect, the bottom line is that the initial impact of monetary policy on interest rates is self-reversing. Therefore, depending on inflationary expectations, low nominal interest rates can be a sign of either tight or easy money. This dilemma bedeviled monetary policy until the work of Milton Friedman and the Great Inflation of the 1970s brought widespread acceptance of the Fisher effect. Indeed, it was not until the Taylor Rule that central banks had an explicit model for adjusting their interest-rate target for this effect. That this rule took so long to develop should be a source of both embarrassment and epistemic humility for economic policy makers.
And here’s what I regard as the most important paragraph of Jeff’s critique:
But the deeper, more critical flaw in Taylor Rules is that the long-run, equilibrium real rate of interest–or what is alternatively called the natural or neutral rate–is also unobservable. Yet these rules make the astonishing assumption that their estimates are not only correct but also relatively fixed and unchanging over extended periods. In short, Taylor Rules virtually preclude any factor, other than central banks, from affecting the equilibrium real rate of interest. A standard rationale for this assumption is what is known as the Ramsay-Cass-Koopmans model. This model estimates the natural interest rate for a closed economy with a fixed number of infinitely-lived households, all identical. Each household has the same rate of time preference, the same declining marginal utility of consumption, and the same rate of population growth. This almost rules out any fluctuations in the natural rate that might arise from alterations in how individuals discount the future, from how consumption preferences may differ among individuals or alter over time for one individual, or from differences in the distribution of wealth.