Kocherlakota on the Fed and the Taylor Rule

The use of policy rules to analyze monetary policy has been a growing area of research for several decades, and the pace has picked up recently. Last month Janet Yellen presented a policy framework for the future centered around a Taylor rule, noting that the Fed has deviated from such a rule in recent years.  A week later, her FOMC colleague, Jeff Lacker, also showed that the Fed has deviated from a Taylor rule benchmark, adding that now is the time to get back.  Last week, the Mercatus Center and the Cato Institute hosted a conference with the theme that deviations from policy rules—including the Taylor rule discussed in my lunch talk—have caused serious problems in recent years.  And this week former FOMC member Narayana Kocherlakota argued that the problem with monetary policy in recent years has not been that it has deviated from a Taylor rule but that it has been too close to a Taylor rule! Debating monetary issues within a policy rule framework is helpful, but Kocherlakota’s amazingly contrarian paper is wrong in a number of ways

First, the paper ignores many of the advantages of policy rules discovered over the years, and focuses only on time inconsistency and inflation bias. I listed the many other advantages in my comment on the first version of Kocherlakota’s paper with the same title: “Rules Versus Discretion: A Reconsideration.” Research by me and others on policy rules preceded the time inconsistency research, and, contrary to Kocherlakota’s claim, the Taylor rule was derived from monetary theory as embodied in estimated models not from regressions or curve fitting during particular periods. (Here is a review of the research.)

Second, Kocherlakota ignores much historical and empirical research showing that the Fed deviated from Taylor type rules in recent years both before and after the crisis, including the work by Meltzer and Nikolsko-Rzhevskyy, Papell, Prodan.

Third, he rests his argument on an informal and judgmental comparison of the Fed staff’s model simulations and a survey of future interest rate predictions of FOMC members at two points in time (2009 and 2010).   He observes that the Fed staff’s model simulations for future years were based on a Taylor rule, and FOMC participants were asked, “Does your view of the appropriate path for monetary policy [or interest rates in 2009] differ materially from that [or the interest rate in 2009] assumed by the staff.”  However, a majority (20 out of 35) of the answers were “yes,” which hardly sounds like the Fed was following the Taylor rule. Moreover, these are future estimates of decisions not actual decisions, and the actual decisions turned out much different from forecast.

Fourth, he argues that the FOMC’s reluctance to use more forward guidance “seems in no little part due to its unwillingness to commit to a pronounced deviation from the prescriptions of its pre-2007 policy framework – that is, the Taylor Rule.” To the contrary, however, well known work by Reifschneider and Williams had already shown how forward guidance is perfectly consistent with the use of a Taylor rule with prescribed deviations.  I would also note that there is considerable evidence that the Fed significantly deviated from it Taylor rule framework in 2003-2005.

Fifth, Kocherlakota argues that the Taylor rule is based on interest rate smoothing in which weight is put on an “interest rate gap.” He argues that this slows down adjustments to inflation and output. But that is not how the rule was originally derived, and more recent work by Ball and Woodford deriving the Taylor rule in simple models does not have such a weight on interest rate gaps.

The last part of Kocherlakota’s paper delves into the classic rules versus discretion debate. Here he mistakenly assumes that rules-based policy must be based on a mathematical formula, and this leads him to advocate pure discretion and thereby object to recent policy rules legislation as in the FORM Act that recently passed the House of Representatives. However, as I explain in my 1993 paper and in critiques of the critiques of the recent legislation, a monetary policy rule need not be mechanical in practice.

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