Fed chair candidate Taylor is woefully misunderstood

With news that the contest for Fed chair is now essentially down to him and frontrunner Jerome Powell, John Taylor’s views have received intense criticism. The third-degree is welcome, since candidates for important policy positions ought to be vetted thoroughly.

But in portraying Taylor as an unyielding hawk whose near mechanical insistence upon his eponymous rule would plunge the economy back into a recession, Taylor’s critics aren’t merely questioning Taylor’s beliefs — they’re torturing them.

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When all of Taylor’s views are considered, he does not deserve the reputation as someone dogmatically attached to a rule raising interest rates. In a 1993 paper, Taylor introduced an analysis for Fed policy that became known as the “Taylor Rule.”

According to the rule, the Fed could keep the economy on an even keel by adjusting its policy interest rate according to a simple formula, the main elements of which are the difference or “gap” between the actual rate of inflation and the Fed’s desired rate, and that between actual economic output and the Fed’s estimate of output when the economy is at “full-employment.”

When both gaps are positive, the formula calls for tightening monetary policy; when both are negative, it calls for loosening. When one gap is negative and the other positive, the bigger gap holds sway.

The Taylor Rule seemed appealing, not just to Taylor himself but to many economists, because it describes fairly well what the Fed had been doing, deliberately or not, during the “Great Moderation,” a remarkable stretch of low inflation and subdued business cycles that ran roughly from the mid-1980s to around 2007.

Even the Fed itself was impressed. Although the FOMC never followed the rule strictly — and Taylor judged that body harshly for some of those deviations — it did use the rule as a reference point in its deliberations.

This, ironically, is where much of today’s criticism of Taylor comes from. If one plugs recent inflation and output-gap numbers into the standard Taylor Rule, one finds that the rule calls for a raising the policy rate much more aggressively than what the Fed’s present plans call for.

But this arithmetic neither completely represents Taylor’s policy positions nor does it prove he’d be a Fed chair that would only ever follow a rigid rule.

Economists Christina and David Romer, of UC Berkeley, proposed a criteria for selecting Fed chairs, in which they highlighted using a nominee’s past remarks in assessing his or her candidacy. This is very useful in analyzing Taylor’s actual stance on policy rules.

Before the crisis and Great Recession, Taylor was quick to caution that a rule should not and could not be implemented mechanically. Instead a policy rule would serve as a useful guide for the Fed.

As the crisis was developing, he reiterated that successfully conducting monetary policy required good judgment and that rules should be thought of as benchmarks not mechanical instructions.

Most recently, at a Boston Fed conference on the monetary rules versus discretion debate, Taylor presented a paper on the history of that debate. There he explicitly said that rules should not be used to tie central bankers to particular decisions.

Rather, when used as guidelines, policy rules can limit uncertainty surrounding monetary policy and improve a central bank’s performance.

Taylor has been consistent, both during and after the crisis, in saying that properly designed monetary policy rules are part of an overall strategy for the central bank, and do not obligate it to specific short-term decisions.  

While Taylor would likely not turn the Fed upside-down by implementing something akin to the Taylor Rule as the chair, there is one area where he might potentially lead the Fed in a new direction.

That is changing the operating framework.

Taylor has argued that he wants to see the federal funds market move from its current floor system, or sub-floor system, back to the pre-crisis model. In that model, the Fed would adjust the quantity of reserves in the banking system and the market would set the short term interest rate. That is very different than the current regime in which the Fed administratively sets its policy rate.

John Taylor has expressed a preference for the Fed returning to its pre-crisis mechanics for monetary policy. He wants to see interest rates determined by market forces. In this, he stands apart from the other candidates.

But he has been consistent throughout his career that monetary rules should serve to guide the central bank, not tie its hands. A proper evaluation of his candidacy would not ignore that fact.

Tate Lacey is a policy analyst at the Cato Institute’s Center for Financial and Monetary Alternatives