Posted by: Dirk | May 28, 2009

Questions for John Taylor

John Taylor, the Taylor in Taylor rule, has written a new book in which he claims that the Federal Reserve Bank caused the financial crisis by providing too much liquidity. In his book Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis he tries to distance himself from the alleged mistakes the Fed made. His argument is that the Fed did not follow the Taylor rule (see excerpt from chapter 1 here):

Figure 1 shows that the actual interest-rate decisions fell
well below what historical experience would suggest policy
should be. It thus provides an empirical measure that mone-
tary policy was too easy during this period, or too “loose fit-
ting,” as The Economist puts it. This deviation of monetary
policy from the Taylor rule was unusually large; no greater or
more persistent deviation of actual Fed policy had been seen
since the turbulent days of the 1970s. This is clear evidence
of monetary excesses during the period leading up to the hous-
ing boom.

The Federal Reserve does not agree with the graph from The Economist and (in 2007 already) had developed its own graph (Figure 1B). The Fed’s Vice Chairman Donald Kohn points out:

As John pointed out, a notable deviation happened beginning in 2002, and I would like to discuss that period to illustrate the limitations I noted earlier.

You can read more about the Fed’s view here. Let me explain how the Taylor rule works. Based on Knut Wicksell‘s work and updated as the New Neo-classical Synthesis, there is a supposed relation between inflation and the interest rate. Hence, if an economy overheats due to too much demand, the resulting inflation can be fought by increasing interest rates. This makes credit more expansive and will harm investment. Inflation should move downwards.

In a weak economy with low inflation, lowering the interest rate will lead to more investment, since credit has gotten cheaper. More investment means more demand, prices will rise in response. It is then the choice of the policy maker which inflation rate is optimal. Using the Taylor rule, the interest rate can be used to get the optimal inflation rate. So much for theory.

Now, Taylor claims that after 09/11 the Fed set the interest rate too low, ignoring the Taylor rule. However, the result was not higher inflation, as predicted by the theory around the Taylor rule. This was surprising. A lower interest rate was supposed to generate higher investment and finally higher inflation. But that never materialized. So there must have been multiple equilibria. Two interest rates generate the same inflation rate. If this is so, the Taylor rule makes no sense, since you cannot know which is the better optimal interest rate and how many of them exist anyway.

I would like to ask John Taylor: Why was there missing inflation when interest rates where brought down after 9/11? Did maybe the cheap credit go into financial markets to fuel a bubble, while consumption was left unchanged? Since your theory ignores financial markets (while others have shown that adding financial markets to it destroys the Taylor rule), isn’t it then your own rule based on faulty theory that has lead to Fed policy that fuelled a fire?

UPDATE 29/05/2009: I suppose that the book is based on this paper by John Taylor from November 2008. It starts, just like the book, with a graph from The Economist.


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