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The Rules of Economy

Question: Should the inflation target implicit in the Taylor Rule change over the business cycle? (Mark Thoma, Economist’s View)

John Taylor: No. I don't think there is any reason to do that. I always assumed the inflation target should be 2%, some people think it should be lower, let's maybe talk about changing it. But, varying it across the business cycle seems to me to be just an extra element of confusion to people. There's no reason to do that.

So, the question for me is how would you adjust it? I think rather than move it around the business cycle is to do as good a job as possible assessing how you measure the inflation target. There has been a lot of confusion, for example, about using the Poor Inflation Rate. I've always preferred to use as a smoothing device, just average the inflation rate over a few quarters, there's actually four quarters in the Taylor Rule. But the Poor rates, especially if they're consistently higher than the headline rates over several years, then -- or lower the other way around, then they can be misleading. So, for one year or so paying attention to the core and looking at that is important, but ultimately, it's the measured inflation rate, the headline inflation rate that's most important and that's what I would focus on. And again, no reason to be changing that, that would just add confusion, add uncertainty to what monetary policy is doing.

 Question: Was the deviation from the Taylor Rule in the early 2000’s severe enough to lead to the problems we’ve had? (Arnold Kling, Econlog)

John Taylor: I think of these as the original cause, if you like. Really, what got the excesses going. It was a big deviation, 300 basis points, we hadn't seen deviations like that since the 1970's, which of course was another period of lots of recessions, a very severe one in '81, '82. So, I think that there is a lot of evidence that says that this was really the factor that got things going in terms of the excesses, the boom, and ultimately the bust in housing, the search for yield, the extra risk taking. And I think you could have guessed that something would happen based on previous periods where central banks have deviated from the Taylor Rule, or other similar guidelines.

It's amazing to me through history and through time how much evidence there is that when central banks deviate from that kind of policy that things don't work out well. We saw that in the United States in the '70's, a terrible time with high inflation and recessions. We've seen it in other countries, and as countries started to follow those principles, things got better. So in some sense now, unfortunately, have another piece of evidence that when policy deviated, we had a big recession. I actually say that the great moderation was ended by the great deviation which has led to this great recession.

Now, I want to be very clear that other things happened that made this situation worse. I made that clear in my book, for example, Getting Off Track, that there really was three things; the deviation from monetary policy rules, the second was misdiagnosing the crisis in the summer of 2007 as a liquidity problem rather than a problem in the banks, and the third was this panic in the fall of 2008, September/October, which I think was largely the result of the rather chaotic government responses to the crisis. So, the deviation was part of it, but there in some sense there are other deviations from policies. Deviations in directions of very interventionist policies to misdiagnoses which is really why this one has been so severe, unfortunately.

Question: What do you think of Goodhart’s law, which suggests that targeting variables for the purpose of policymaking leads to those variables becoming misleading?

John Taylor: Well, Charles Goodhart makes a good point with that, that the policy responses actually affect individual behavior. I think it's what makes policy difficult. I think you can take account of those and be wary of them and still have conducted policy.

I'll give an example. I think when bond traders, people in the markets have a sense of what monetary policy is going to be like, then they will price securities, long run securities and medium run securities based on that. If the policy moves to something else, say for example, deviates from had been working, then it takes them a while to figure out what's going to happen, but they will adjust. They will adjust their forecasts, their procedures, their rules of thumb, sometimes indirectly, sometimes somewhat inadvertently they'll do it. So, that's the adjustment.

But, that's why we like our policies to be as predictable as possible sot hat people can make these adjustments. So, I would say, this is to me Goodhart's Law is another reason not to be changing from a policy that's worked well. I'd say not to do too much fine tuning. In a way, what Goodhart's Law shows you is that efforts to fine tune can actually be something that's harmful. In fact, I think the period in the early, say 2002-04 period, that could very well be explained by an effort to make policy even better than it was during the great moderation, if you like. Trying to fine tune an extra way, bring rates below what had worked before. But those are all fine tuning things and I think what messages such as Goodhart's Law show you is that the reaction to those can sometimes be hard to predict. People will begin to see that there's another target, there's another idea. You're moving away from the equilibrium and that's a reason, I think, to keep it simple, if you like. Keep the policy as simple as possible, keep the regulations as simple as possible, and that's true of both monetary policy and fiscal policy.

 Recorded on December 21, 2009

Was the deviation from the Taylor Rule in the early 2000’s severe enough to lead to the problems we’ve had? Its creator explains.

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