Economics One

Many are worried that the exploding Federal debt and the expanded Federal Reserve Balance sheet will lead to a large increase in inflation. But when and how fast? A session at the recent American Economic Association meetings on the Great Inflation of the late 1960s and 1970s provides some historical perspective on the question. Andrew Levin of the Federal Reserve Board staff and I presented one of the papers. We looked at the timing of the inflation increase and the monetary responses.

On New Years Day I wrote a piece on the surprising increase in the number of references to the Taylor rule in 2009. Little did I know that two days later Federal Reserve Board Chairman Ben Bernanke would start off 2010 with a speech with 50 more references at the American Economic Association (AEA) meeting in Atlanta. The speech was largly an attempt to refute the now commonly held view that the Fed held interest rates too low for too long in 2002-2005. I was in Atlanta and though I could not go to the speech I read it afterwards and expressed by disagreement first in a Bloomberg interview with Steve Matthews and later in a CNBC interview with Larry Kudlow and will follow up with more details; note that a working paper prepared by seven Fed Board staff was released just before the speech. Others have raised questions about the speech from a variety perspectives, including David Beckworth, Caroline Baum, David Leonhardt, Mike Shedlock, Judy Shelton. There is much for the Financial Crisis Inquiry Commission to digest.

Surprisingly, the Taylor rule was referred to more frequently than ever in 2009. According to Google Scholar more articles referred to it than in any year since 1993 when John Lipsky, now First Deputy Managing Director at the IMF, first called the rule by that name. Many more pieces appeared in blogs or in the news media.

The increased commentary is surprising because the Fed did not change its interest rate target once during 2009. Most likely the reasons for the attention are that: (1) the rule is cited as evidence that interest rates were “too low for too long” in 2003-2005 thereby helping to cause the financial crisis, (2) the rule can be used to help determine when the Fed should or will increase its interest rate target above zero, (3) the rule is used by some to determine how much quantitative easing is needed.

Many excellent pieces were written, in my view, including several by Michael Woodford of Columbia and Vasco Curdia of the New York Fed on adjusting policy rules during financial crises. 2009 also saw the release of the 2003 FOMC transcripts with telling references to the Taylor rule by Ben Bernanke. Columns by Michael McKee of Bloomberg and Gene Epstein of Barron’s were clear and insightful.

At the other end of the spectrum was Brad DeLong’s recent Taylor rule blog post, which unfortunately contains serious errors. For starters, he asserts that “John Taylor in the long run wants ‘Taylor Rule’ to mean any statistically-fitted reaction function in which interest rates respond to inflation and the output gap and not to the one rule he fitted over 1987-1992.” In my original paper I did not “statistically fit” a reaction function over 1987-1992 or any other period for that matter. The coefficients of the rule in that paper were derived from monetary theory and models developed during the 1980s. As I explained in the paper, using a variety of quantitative economic models, I found, through stochastic simulations, that such a rule worked well in stabilizing inflation and real GDP. Statistically fitting such a rule over a short five-year span would make little sense and adding earlier years would have made even less sense because Fed policy during the 1970s was terrible. To illustrate how the rule would work in practice I pointed to episodes when the rule was similar and also to episodes when it was different from what the Greenspan Fed was doing. There are no reaction function regressions in that paper.

De Long also tries to make the case that a policy rule which was statistically fit by San Francisco Fed economist Glenn Rudebush is an improvement over the rule I proposed. That estimated rule has a larger coefficient on the output gap and therefore gives lower interest rate settings now. It implies that the interest rate will remain at zero for a very long period which is what DeLong advocates. He likes that estimated version, but curve fitting without theory is dangerous. In the case of policy rules, it can perpetuate mistakes: the higher coefficient on the gap may be due to periods when the funds rate was too low for too long. Also interpretation of the lagged interest rate in fitted regressions is very difficult.

DeLong provides no demonstration that a higher coefficient on the output gap is an improvement over my original proposal. The recent review paper by me and John Williams, Director of Research at the San Francisco Fed, reviews the debate over the size of that coefficient and shows why a higher coefficient is not robust. Moreover, others, such as Bob Hall, argue that the coefficient on the output gap should be lower, not higher, than in the Taylor rule because of uncertainty of measuring the output gap. DeLong does not mention such alternatives.

DeLong is wrong about what he claims “John Taylor in the long run wants.” Don’t we all want good monetary policy? If there is a better policy rule that improves economic performance, then I am all for it, and I don’t much care what you call it. In 2008 I proposed adjusting the Taylor rule with the Libor-OIS spread to deal with the turbulence in the financial markets. The Curdia and Woodford papers analyzed that proposal and improved on it by changing the coefficient on the Libor-OIS spread. Their analysis was not based on statistical curve fitting, but rather on good monetary economics, which is what we need more of right now.

Some of the big questions looming about the Fed’s exit strategy are if, when, and at what pace the Fed should draw down its huge portfolio of mortgage backed securities (MBS). At its meeting last week the Federal Open Market Committee announced that it is continuing its MBS purchases at a “gradually slowing pace,” but that will still leave $1,250 billion in MBS on its balance sheet at the end of the first quarter. Another, more long-term, question is whether such price-keeping operations—a term used by Peter Fisher who once ran the trading desk at the New York Fed—should be a regular part of monetary policy in the future. Brian Sack, who now runs the trading desk, concludes in a recent speech that they should be.

The answer to these important questions requires on an empirical assessment of the impact of the MBS purchase program. Unfortunately, publicly available assessments are sorely lacking. For this reason, Johannes Stroebel and I undertook an econometric study of the impact; the study is part of a larger research project by us and our colleagues on central bank exit strategies.

Such an assessment requires that one carefully consider other influences on rates on mortgage backed securities. We focused on two obvious ones: prepayment risk and default risk. If we control for prepayment risk using the swap option-adjusted spread, which is regularly used by MBS traders and investors, and if we control for default risk using spreads on senior or subordinated agency debt, we find that that the program has not had an economically or statistically significant effect on mortgage spreads. If we use other measures to control for prepayment and default risk we can see statistically significant effects, but they are small. Even in these cases it was the announcement or the existence of the program, rather than the size of the portfolio that mattered for spreads. We find that there is no statistically or economically significant effect of the size of the portfolio, a finding which we show is quite robust. If our estimates hold up to scrutiny, they raise doubts about such price-keeping operations and suggest that the Fed could gradually reduce the size of its portfolio without a significant impact on the mortgage market.

The graph illustrates our findings. It shows the swap option adjusted spread (with its prepayment risk adjustment) in red and the predictions of that spread using the agency debt spread (a measure of risk) in blue. The residual between these two, shown in green at the bottom of the graph, indicates that there is little left for the Fed’s MBS portfolio to explain. Details and other cases are in the paper.

Big Think is conducting a series of video interviews with economists, market participants, journalists, policymakers and others on the financial crisis to try to answer the pressing question of “what went wrong.” This is an excellent idea. As former Treasury Secretary Nicholas Brady said last week “you can’t fix what you can’t explain.” The Financial Crisis Inquiry Commission should take note.

The interview with David Wessel of the Wall Street Journal was the first in the series. Among many good questions put to David, one of the most interesting was “Did Bernanke’s mantra of ‘whatever it takes’ lead us astray?” In David’s 575-word answer, he offers 5 positive words that it “got us through this crisis,” but gives no explanation for that and instead goes on for the remaining 570 words talking about the problems the approach has caused and is causing, including that “it can justify almost anything.” Among other problems he mentions the Bernanke-Paulson-Geithner “mistake” of “wasting the time after Bear Stearns” and “not coming up with a more articulated game plan for what they would do if they had to cope with a collapse with another financial institution.” In effect what you see in the video is a cogent argument that the approach may have seriously worsened the crisis even if it eventually got us through it. So it seems like the answer to the question is: yes, it led us astray. And since the problem has not been addressed–as David points out in the last few sentences—it is likely to continue to lead us astray.