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The Next Unsolved Mystery

Question: Do you think the Federal Reserve Board should target asset bubbles like the asset bubble? (Dean Baker, Beat the Press)

John Taylor: No, I don't think they should target bubbles like that. The impacts of monetary policy occur with long variable lags as Norton Friedman showed many years ago and we've seen a lot of evidence of timing to deal with bubbles leave a lot to be desired. But more important, I don't think that has been the problem with respect to monetary policy. Certainly not in this serious crisis. I think to have the interest rates too low for too long in the 2002, 2003, 2004 period was really effectively inducing a lot of the bubbles and asset prices, especially housing.

So, if interest rates were higher, closer to what they would have been under the policy followed in most of the '80's and '90's, then I think we wouldn't have had nearly as much as a boom and bust problem. Not as much of a bubble as we had. So until policy can stop preventing bubbles; it seems to me that’s the number one priority, and the fact that people think they are some how possible to bust them, it seems to me that is not really feasible, and let's get back to the policies of really most of the '80's and '90's that was working without serious bubbles. The bubble problem, the housing problem, this crisis occurred primarily because of policy getting off track, let's get it on track first and then worry about the bubbles.

I think the bubbles will be must less of a problem. They're not going to disappear of course, but much less of a problem if monetary policy followed the kind of actions we had through much of the '80's and '90's.

 Question: Would you advocate an aggressive strategy of quantitative easing? (Dean Baker, Beat the Press)

John Taylor: Well, the question is; given that the Taylor Rule has large negative interest rates right now, would I want more quantitative easing? First of all, I don't think the Taylor Rule does show a large negative interest rates right now. That's kind of a myth. The Taylor Rule is pretty simple. It just says, the interest rate should equal 1 1/2 times the inflation rate, plus 1/2 time the GDP gap, plus 1. Well, if you plug in reasonable estimates for what inflation is and what the GDP gap is, I get a number that’s pretty close to zero. Not minus four, minus five, not numbers like that. So, in fact I would say the amount of quantitative easing could be reduced right now. I hope it is reduced in a gradual way. Some of the mortgage purchases I think could be slowed down and then actually reversed.

So, the question is a good one, and I'm glad it was asked because there is a lot I think, of misinformation out there about what the Taylor Rule says. The Taylor Rule is very simple, as I just mentioned. You can say it in a sentence and you plug in the numbers, you don't get minus five, minus six percent. You get something much closer to zero where the interest rate is now. Now, that of course has implications going down the road because it says, to the extent that real GDP picks up; I hope it does, or if inflation picks up; hope it doesn't. But if either of those occur, then you'd have to see interest rates starting to move above the zero to 25 basis point range. And if we don't then we're going to be back in the same kind of situation we were in 2002 through 2004, and that of course could begin to induce bubbles and we certainly don't want that to happen.

Question: Would quantitative easing speed the recovery? (Mark Thoma, Economist’s View)

John Taylor: No. I don't think quantitative easing at this point would effectively smooth the recovery. I think right now, based on historical experience, the interest rate is about where it is, it's not that we don't need a lot of quantitative easing. We've had some and I think the job of the Fed now is to bring it back. They're talking about doing that, which is good. But I think, for me, the most important thing now for policy to have a good recover is to reduce this tremendous amount of uncertainty that exists with both monetary policy and fiscal policy and the uncertainty for monetary policy is, we don't know how rapidly the quantitative easing will be reversed. We don't know what's going to happen with interest rates. There is a lot of questions there. So I’d say, get back to the things that were working during the great moderation period, the '80's and '90's primarily, and that means letting interest rates rise appropriately and reducing the amount of quantitative easing; getting back to where it was through most of policy of the '80's and '90's.

Question: What is the most important unresolved question in monetary economics? (Mark Thoma, Economist’s View)

John Taylor: I think the most important unresolved question of monetary economics is the interaction between the financial sector and monetary policy. There's been lots of thinking about it over the years, some of it actually done here at Stanford; Girly and Shaw. A lot of it done by Tobin at Yale, Ben Bernacke has done some of it. But I think the most promising part is the combination of the newest work on pricing of bonds and securities. A lot of it's done by Monica Busasy[ph] and some of her colleagues, that combine that with monetary policy so that you have a sense of what's going to happen to longer term rates when the short rate is reduced. What's going to happen to credit flows and how much are credit flows going to impact the economy?

This crisis has been very clear in demonstrating that more work on the connection between the financial economics and monetary policy is needed. In fact, there's still a lot of questions out there in policy about whether the financial markets performed well, or not. It seems to me, if you look at them, they absorbed a tremendous shock from policies. It's effectively a panic induced by some ad hoc policy changes and they responded quickly and they responded in a way which has been smooth, as the markets themselves. The institutions, the financial institutions of course, have been in great difficulty, but the markets themselves have worked well.

So, to me, where we should focus our attention really is this connection between the financial markets, including the financial institutions and the monetary policy itself.

Question: How important is Fed independence? (Mark Thoma, Economist’s View)

John Taylor: I think we need to have both independence and accountability. They go together. It's not one or the other. So, in answer to the question, how important is Fed independence? I say it is very important, but it needs to be matched with accountability.

A lot of the concerns that you're seeing in the Congress, in the country about the Fed; the Ron Paul bill, I think that's a reaction to what looks like a very interventionist action by the Federal Reserve. Not a lot of descriptions of how it actually occurred, there's no reports on what's called a Section 13-3 Intervention. Section 13-3 of the Federal Reserve Act which allows for such actions, but there’s very little reporting on how it actually took place.

So, I think the best thing the Fed can do to get back some of its independence, and quite frankly, I think it's lost a little bit in this crisis. The best thing it can do is be very accountable about some of the interventions in Section 13-3, that's where most of the transparency concerns exist at this point, and then of course to emphasize that the policy that has worked most well was the policy of the '80's and '90's and when we got off track on that, things deteriorated.

I think that some recognition of interest rates being so low for so long in the '02 to '04 period by the leadership would be very important. It’s discussed in the Fed system, is discussed by other central banks, it's discussed quite widely, but some recognition of that seems to me would be important in terms of bringing back some of the independence that the Fed lost.

So, I think that independence, just to summarize, is really important, it's essential, we've seen evidence over time about how it is. But it has to be matched with a strong sense of accountability to the Congress and to the American people of what the Fed is actually doing.

Question: Should the Fed be engaging in purchases of mortgage-backed securities, or is that a role for another government agency?

John Taylor: I think it's not the thing the Federal Reserve should be doing. I think the Fed should be focusing on the overall level of interest rates, not trying to intervene in certain sectors.

 A year ago I wrote a paper and presented at the annual meetings of the economists arguing that this was what I called mundustrial policy. It's using monetary policy to intervene in certain sectors, certain firms of course is part of that as well. So, I think it would be better if monetary policy did not do that. I’ve just completed a study trying to look at the impacts of the purchases of the mortgaged-backed securities by the Fed and I actually don't think there is large – had as large an impact on rates as many people believed. We'll be studying that for a while.

But more important, the impact is quite unreliable. It's very hard to measure. A lot of uncertainties. So, the notion that the Fed could go into business of controlling the mortgage rates as it has effected the funds rate for years I think is really a mistake and wishful thinking. It would take the Fed in the wrong direction.

So, the more we can get back to a monetary policy which is focusing on the overall level of the money supply, the overall level of the interest rates rather than intervene in certain sectors the better. That's not monetary policy. That's the kinds of things that raise people doubts about monetary policy. They question, why should an independent agency of government be intervening in certain sectors like that? The Treasury has bought mortgage-backed securities. That doesn't raise the same independence questions that the Fed has raised by these purchases.

So, it's one of the biggest issues now to address. If you read, for example, Brian Sachs' recent speeches at the New York Fed, he acts as if this is like a new instrument for monetary policy in the future. One of his predecessors, Peter Fisher, who is now at Black Rock, calls this "price keeping operations." And I think there is a huge amount of doubts about this; it's effectiveness, it's reliability, and it raises questions about the Fed's independence.

So, I feel strongly that this is not the kind of thing that we should have the Fed doing in the future.

Recorded on December 21, 2009

We need to study the connection between the financial markets and the monetary policy itself, says economist John Taylor.

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