Economics One

President Obama just widened the race for Fed chair. Up on Capitol Hill he mentioned Don Kohn along with Larry Summers and Janet Yellen. So we should widen the hunt for things that Don has said that help answer the key question I asked in a recent blog about Summers and Yellen: “who is more most likely to implement a monetary policy that will help keep us out of a serious financial crisis, and create price and output stability more generally. In other words who will implement a more predictable, less interventionist, more rules-based monetary policy strategy of the kind that has worked well when tried, as in the 1980s, 1990s and until recently?”   

I know that Don has thought deeply about rules-based monetary policy. As Don put it in a 2007 speech at the Dallas Fed, he and I “have spent countless hours discussing how the Federal Reserve arrives at decisions about monetary policy and how it should arrive at decisions.  Those conversations began in earnest in the late 1980s, when [I] was on the Council of Economic Advisers, and they have continued to the present day.  They have occurred not only in offices and classrooms in Washington and Stanford and at numerous conferences around the globe, but also around dinner tables in Washington and Palo Alto and on hiking trails from Vermont to Wyoming.”

In that same speech Don listed “Three Benefits of Simple Rules in Monetary Policymaking.” I’ll just quote the key phrases without comment, so you can get a sense of what Don says in his own words.

First, “a simple rule…can provide a useful benchmark for policymakers.  It relates policy setting systematically to the state of the economy in a way that, over time, will produce reasonably good outcomes on average.” 

Second, “simple rules…help financial market participants form a baseline for expectations regarding the future course of monetary policy.” 

Third, “simple rules can be helpful in the central bank’s communication with the general public.  Such an understanding is important for the transmission mechanism of monetary policy.” 

But Don points out that “Simple rules have limitations…” He mostly uses the Taylor rule as an example: 

First, “the use of a Taylor rule requires that a single measure of inflation be used to obtain the rule prescriptions…. To be sure, over long periods, most of these measures behave very similarly.  But policy is made in the here and now, and the various indexes can diverge significantly for long stretches, potentially providing different signals for the appropriate course of monetary policy.

Second, “the implementation of the Taylor rule and other related rules requires determining the level of the equilibrium real interest rate and the level of potential output; neither of them are observable variables, and both must be inferred from other information.” 

Third, “using simple rules for monetary policymaking stems from the fact that, by their nature, simple rules involve only a small number of variables.  However, the state of a complex economy like that of the United States cannot be fully captured by any small set of summary statistics.” 

Fourth, “simple policy rules may not capture risk-management considerations.  In some circumstances, the risks to the outlook or the perceived costs of missing an objective on a particular side may be sufficiently skewed that policymakers will choose to respond by adjusting policy in a way that would not be justified solely by the current state of the economy or the modal outlook for output and inflation gaps.”   

Don “offered this analysis in the spirit of so many of the discussions” I had with him.  While his bottom line was that “it’s not so simple to use simple rules!” you really get the sense that he would like to do so.

The financial press has narrowed down the race for the next Fed Chair to Larry Summers and Janet Yellen. Though there are other candidates with Democratic credentials, such as Alan Blinder and Tim Geithner, most stories are about a pairwise comparison: Between Summers and Yellen, who is closer to Barack Obama, more able to get along with Wall Street, more dovish, or better able to intervene in a serious financial crisis?

But the most important question is who is more likely to implement a monetary policy that will help keep us out of a serious financial crisis, and create price and output stability more generally. In other words who will implement a more predictable, less interventionist, more rules-based monetary policy strategy of the kind that has worked well when tried, as in the 1980s, 1990s and until recently?

Janet Yellen has spoken at length about this issue, and though Larry Summers has recently been in “radio silence” mode, he did discuss the issue in a debate I had with him last year at Stanford.  So there is a basis for comparison using each person’s own words. And because Summers and Yellen both chose to discuss rule-like policy in terms of the Taylor Rule, it is not an apples and oranges comparison.

Here is what Janet Yellen has been saying about rules-based monetary policy, drawn from her speech of last November:

Many studies have shown that, in normal times, when the economy is buffeted by typical shocks—not the extraordinary shock resulting from the financial crisis—simple rules can come pretty close to approximating optimal policies. In fact, empirical research suggests that a modified version of the original Taylor rule fits the behavior of the Fed reasonably well from the late 1980s until the financial crisis. Given that participants in financial markets are familiar with both the FOMC’s historical behavior and simple rules, the communications challenges might arguably be less severe if the FOMC followed such a strategy. To be sure, I would never advocate turning over monetary policy to a computer, but why shouldn’t the FOMC adopt such a rule as a guidepost to policy?  The answer is that times are by no means normal now, and the simple rules that perform well under ordinary circumstances just won’t perform well with persistently strong headwinds restraining recovery and with the federal funds rate constrained by the zero bound.

So, though Yellen rationalizes the departure from rules-based policy, she at least wants to get back to rules-based policy in normal times, largely because that will help, in her view, maintain greater macroeconomic stability.

In contrast, here is what Summers said at the Stanford debate (based on a video recording):

The Fed’s job is to set monetary policy and it may or may not have done the right job….Look, on monetary policy I have enormous respect for the Taylor Rule, but it is not yet the law of the land.  So to call the failure to follow the Taylor Rule an argument that the government is somehow acting excessively and being the cause of the problem…  I mean, yes.  I think government should act more wisely in their macroeconomic policies.  I think we probably can agree on that proposition.  And I’m not choosing to argue with you on the proposition that the Taylor Rule would have represented more wise monetary policy at some point…. Look, are there things that were done in the wake of crisis that in with the benefit of hindsight you would have done differently?  Of course.  …was the right policy to have less government?  I don’t see how you can come down on any side other than, thank God we had an activist government.

Like Yellen, Summers rationalizes the recent discretionary deviations from rules-based policy as due to special factors, but his words reveal less willingness to endorse a rules-based policy strategy, even in normal times, with a preference that government officials should simply “act more wisely” in their discretionary interventions.

In Jared Bernstein’s interesting recent piece “Checking in on the Taylor Rule and the Fed,” he writes that the federal funds rate has been “camping out at between -1 and -2 percent” according to the Taylor Rule.

He then goes on to give this definition the Taylor Rule: The federal funds rate should equal

                                                       2 + p + 0.5(p – 2) + y  

where p is year-over-year percent change in the PCE inflation index and y is the output gap: 2*(nairu-unemp) where 2 is the Okun coefficient and the nairu is from CBO.

But this is not the policy rule I recommended in a 1993 paper using a formula which has come to be called the Taylor Rule. Here is the formula copied from that paper*

The two equations may looks similar, but there is a key difference. Bernstein’s formula leaves off the .5 coefficient on y.  Thus, he effectively doubles the impact of the output gap on the interest rate compared to what I recommended then—and still recommend now.

How much difference does this make?  For the first quarter of this year, I calculate that Bernstein’s output gap (y) is about  -4.4% [that is, 2*(5.5- 7.7)]. So if you use 0.5 rather than 1.0 for the coefficient on y, the interest rate would be 2.2 percentage points higher than Bernstein calculates. (The difference was much larger in 2009 and 2010 when the gap was larger). Adding back in the 2.2% puts the interest rate into positive territory (say 0.7% rather than -1.5%), which would mean that the zero-lower-bound on the federal funds rate is not “a serious macroeconomic constraint on policy” contrary to what Bernstein argues.  That constraint is the rationale for quantitative easing and forward guidance.

I realize that there are differences of opinion about what is the best rule to guide policy and that some at the Fed (including Janet Yellen) now prefer a rule with a higher coefficient. But at the least people should be cross-checking below-zero interest rate calculations and debating the difference with other approaches when the Fed’s rationale for purchasing $85 billion per month of mortgage-backed and Treasury securities hangs on those calculations.

There are other important cross-checks on such calculations. Bernstein’s estimate of the output gap uses an Okun’s law coefficient of 2, but if you use 1.5 (the empirical estimate over the past 50 years) rather than 2, the gap is smaller, which also moves the rate up toward positive territory.  Similarly, the average of the San Francisco Fed’s most recent survey of output gaps is smaller than what Bernstein uses. And the inflation rate over the past 4 quarters with the GDP price index is higher than with the PCE price index used by Bernstein; that cross-check also pushes the interest rate toward positive territory.

*Discretion Versus Policy Rules in Practice, Carnegie-Rochester Series on Public Policy, North-Holland, 39, 1993, pp. 195-214

Some of the points Paul Krugman makes in his response to my article in today’s Wall Street Journal criticizing unconventional monetary policy are irrelevant.  The others are wrong.

First, he goes after other people who are critical of the unconventional policy, as he has done before. He says they are wrong because inflation has not picked up yet, as he has said before.  But my concerns have been about a two-sided risk, with downside effects on the economy due to the uncertainty about the exit, the distortions of financial markets (including the Fed replacing several large markets with itself), the international repercussions which feed back on the U.S. economy, and other unintended consequences.   Unfortunately, those downside risks have panned out with a terrible economic recovery to show for it. Paul Krugman downplays this argument saying that it is just “about financial stability.” No, my concern has been about the economy and unemployment.

Second, Paul Krugman does not mention other critics who I referred to the article, such as Paul Volcker, Peter Fisher, and Raghu Rajan, who have serious misgivings about the Fed’s quantitative easing based on their own policy and market experience. It’s clearly not only an inflation worry for them.

Third, he misreads the history of the mid-1970s and how it may apply today.  At that time a consensus steadily grew around Milton Friedman’s view that monetary policy was not working in its aim to reduce unemployment. But people argued against stopping the policy because the short run costs were high, even if there were long run benefits of a new policy.

Fourth, in his long paraphrase of my argument, Krugman says that my view about the exit from unconventional policy is that “in fact it would have no cost.”  But that is precisely the opposite of what I have been saying. A major concern of mine has been the costly exit.

Fifth, he says I want to “stop it immediately.”  No, I have argued that the Fed needs to have a gradual and credible exit strategy.