This week was monetary policy week in Economics 1 at Stanford. It was also monetary policy week in Washington: the House Financial Services Committee surprisingly voted 43-26 for Ron Paul’s controversial bill to audit the Fed; the TARP inspector general found that the Fed’s AIG bailout was unnecessarily generous to creditors; and people continued to debate how long the Fed could hold the interest rate at zero without threatening the dollar.
To discuss the interest rate decision in my lectures, I made use of the Taylor Rule, a guideline for the Fed and other central banks to use in setting interest rates. To start I showed the students how to derive the rule from economic theory. Actually, the students derived the rule on their own–with the help of a little Socratic questioning–even choosing the signs of the coefficients and the target inflation rate (2 percent) correctly. I was happy to welcome the NewsHour’s Paul Solman and his camera crew who came to film part of this lecture. Here’s my paper on what others would later call the Taylor Rule
The Taylor Rule says the interest rate should equal one-and-a-half times the inflation rate plus one-half times the GDP gap plus 1. Rounding off to the nearest percent, inflation is running around 2 percent and the GDP gap around -8 percent, so the rule says the interest rate should be near 0, (1.5 x 2 + .5 x (-8) + 1 = 0) which is about where the Fed is now. As the economy recovers and real GDP increases, the Fed should raise rates. If inflation picks up too, it will have to do so more rapidly.
Several columnists and bloggers also used the Taylor Rule this week, including Gene Epstein of Barron’s in “Better Baking for the Bank: The Right Recipe for Rates.” The recommended interest rate setting can vary a bit because of different estimates of the inflation rate and the GDP gap (the percentage difference between real GDP and potential GDP). Epstein also finds the interest rate to be close to zero, but slightly higher at 0.6 percent.
But sometimes you read really wild things about what the interest rate should be. Paul Krugman’s Monday piece about the Taylor Rule is an example. He says he likes to use an estimate of the Taylor Rule. But the estimate is much different from the Taylor Rule, so he gets a much different interest rate setting of -7 percent! This implies that we are unlikely to see a positive interest rate for many years, which would be dangerous for the stability of dollar let alone the stability of the U.S. and world economy. I explained the problems with using such estimates in a Bloomberg oped several months ago. Estimates can perpetuate past mistkes. In the current environment they could lead to a repeat of the same mistakes that led to this deep recession. Michael McKee, in another Bloomberg opinion piece , suggested a line for me from Woody Allen’s Annie Hall, where Marshall McLuhan makes an appearance and tells an academic pontificating about McLuhan: “you know nothing of my work!”