New Study Questions Justification for Quantitative Easing

Proponents of Quantitative Easing frequently cite—inappropriately in my view—the Taylor Rule as support, saying that the rule calls for a federal funds rate as low as minus 6 percent, well below the zero bound. But in various pieces over the past year, such as Taylor Rule Does Not Say Minus 6 Percent, I have argued the contrary. If you simply plug in current inflation and output (gap) you will find that the interest rate is above zero with the policy rule coefficients I originally derived. But QE II proponents change the coefficients. Frequently they use a higher coefficient on output (around 1.0) rather than the lower coefficient (0.5) which I originally recommended. The higher coefficient on output gives a much lower interest rate now and is thus used by proponents of quantitative easing.

A new paper by Alex Nikolsko-Rzhevskyy and David Papell provides important evidence relevant to this debate. They show that, if history is any guide, the higher coefficient would lead to inferior economic performance compared with the original coefficient I recommended.

First, they look at the 1970s when monetary policy was too easy: in much of this period the interest rate was too low creating high inflation and eventually high unemployment. They show that the higher coefficient on output would have perpetuated the bad policy while the lower coefficient would have prevented it.

Second, they look at years in the 1990s when monetary policy is widely viewed as good, helping to create a long expansion. Here they show that the higher coefficient would have prevented this good policy. Actual policy was more consistent with the lower coefficient which I had proposed.

In sum, they find no reason to use a higher coefficient, and that the lower coeffcient works better. David Papell’s guest blog yesterday on Econbrowser nicely puts these new results into the context of today’s policy debate and provides more details. He emphasizes that his paper with Nikolsko-Rzhevskyy does not endeavor to estimate the impact of QEII, but rather shows that the typical policy rule rationale for this discretionary action is flawed. In my view it is an example of “discretion in policy rule’s clothing.”

About John B. Taylor 117 Articles

Affiliation: Stanford University

John B. Taylor is the Mary and Robert Raymond Professor of Economics at Stanford University and the Bowen H. and Janice Arthur McCoy Senior Fellow at the Hoover Institution. He formerly served as the director of the Stanford Institute for Economic Policy Research, where he is now a senior fellow, and he was founding director of Stanford's Introductory Economics Center.

Taylor’s academic fields of expertise are macroeconomics, monetary economics, and international economics. He is known for his research on the foundations of modern monetary theory and policy, which has been applied by central banks and financial market analysts around the world. He has an active interest in public policy. Taylor is currently a member of the California Governor's Council of Economic Advisors, where he also previously served from 1996 to 1998. In the past, he served as senior economist on the President's Council of Economic Advisers from 1976 to 1977, as a member of the President's Council of Economic Advisers from 1989 to 1991. He was also a member of the Congressional Budget Office's Panel of Economic Advisers from 1995 to 2001.

For four years from 2001 to 2005, Taylor served as Under Secretary of Treasury for International Affairs where he was responsible for U.S. policies in international finance, which includes currency markets, trade in financial services, foreign investment, international debt and development, and oversight of the International Monetary Fund and the World Bank. He was also responsible for coordinating financial policy with the G-7 countries, was chair of the working party on international macroeconomics at the OECD, and was a member of the Board of the Overseas Private Investment Corporation. His book Global Financial Warriors: The Untold Story of International Finance in the Post-9/11 World chronicles his years as head of the international division at Treasury.

Taylor was awarded the Alexander Hamilton Award for his overall leadership in international finance at the U.S. Treasury. He was also awarded the Treasury Distinguished Service Award for designing and implementing the currency reforms in Iraq, and the Medal of the Republic of Uruguay for his work in resolving the 2002 financial crisis. In 2005, he was awarded the George P. Shultz Distinguished Public Service Award. Taylor has also won many teaching awards; he was awarded the Hoagland Prize for excellence in undergraduate teaching and the Rhodes Prize for his high teaching ratings in Stanford's introductory economics course. He also received a Guggenheim Fellowship for his research, and he is a fellow of the American Academy of Arts and Sciences and the Econometric Society; he formerly served as vice president of the American Economic Association.

Before joining the Stanford faculty in 1984, Taylor held positions as professor of economics at Princeton University and Columbia University. Taylor received a B.A. in economics summa cum laude from Princeton University in 1968 and a Ph.D. in economics from Stanford University in 1973.

Visit: John Taylor's Page, Blog

2 Comments on New Study Questions Justification for Quantitative Easing

  1. Why does a formula have to change if it is indeed correct? Taylor’s rule is as right as using the FFR is right. Taylor’s rule uses data that make it impossible for a train to stop in time, or a boat to turn in order to avoid the rocks any lighthouse would reveal. It’s VooDoo economics.

  2. The censors were unable to understand my comment. Dude, gDp (used in the Taylor rule), is only published quarterly (with one month’s delay, no I take that back, April 28 for 4th qtr 2010) & then its revised twice (in successive months). That is a useless equation.

    There is a “Holy Grail”:

    First, there is no ambiguity in forecasts: In contradistinction to Bernanke (and using his terminology), forecasts are mathematically “precise” :
    (1) “Money” is the measure of liquidity; the yardstick by which the liquidity of all other assets is measured.

    (2) Income velocity is a contrived figure (fabricated); it’s the transactions velocity (bank debits – Vt) that’s important (i.e., financial transactions are not random);

    (3) Nominal GDP is the product of monetary flows (M*Vt) (or aggregate monetary purchasing power), i.e., our means-of-payment money (M), times its transactions rate of turnover (Vt).

    (4) The rates-of-change (roc’s) used by economists are specious (always at an annualized rate; which never coincides with an economic lag). The Fed’s technical staff, et al., has learned their catechisms;

    (5) Friedman became famous using only half the equation (the means-of-payment money supply), leaving his believers with the labor of Sisyphus.

    (6) Contrary to economic theory, & Nobel laureate, Dr. Milton Friedman, monetary lags are not “long and variable”. The lags for monetary flows (MVt), i.e. the proxies for (1) real-growth, and for (2) inflation indices, are historically (for the last 97 years), always, fixed in length. However, the FED’s target, nominal gdp?, varies widely.

    (7) Roc’s in (MVt) are always measured with the same length of time as the specific economic lag (as its influence approaches its maximum impact (not date range); as demonstrated by the clustering on a scatter plot diagram).

    (10) Asset inflation, or economic bubbles, are incorporated: including housing, commodity,, dot.com, etc. This is the “Holy Grail” & it is inviolate & sacrosanct: See 1931 Committee on Bank Reserves Proposal (by the Board’s Division of Research and Statistics), published Feb, 5, 1938, declassified after 45 years on March 23, 1983.
    http://fraser.stlouisfed.org/docs/meltzer/bogsub020538.pdf

    (11) The BEA uses quarterly accounting periods for real GDP and the deflator. The accounting periods for GDP should correspond to the specific economic lag, not quarterly.

    (12) Monetary policy objectives should not be in terms of any particular rate or range of growth of any monetary aggregate. Rather, policy should be formulated in terms of desired roc’s in monetary flows (MVt) relative to roc’s in real GDP.

    (13) Combining real-output with inflation to obtain roc’s in nominal GDP, can then be used as a proxy figure for roc’s in all transactions. Roc’s in real GDP have to be used, of course, as a policy standard.

    (14) Because of monopoly elements, and other structural defects, which raise costs, and prices, unnecessarily, and inhibit downward price flexibility in our markets, it is probably advisable to follow a monetary policy which will permit the roc in monetary flows to exceed the roc in real GDP by c. 2 – 3 percentage points.

    (15) I.e., monetary policy is not a cure-all, there are structural elements in our economy that preclude a zero rate of inflation. In other words, some inflation is inevitable given our present market structure and the commitment of the federal government to hold unemployment rates at tolerable levels.

    (16) Some people prefer the “devil theory” of inflation: “It’s all Peak Oil’s fault”, ”Peak Debt’s fault”, or the result of the “Stockpiling of Strategic Raw Materials/Industrial Metals” & Soaring Agriculture Produce. These approaches ignore the fact that the evidence of inflation is represented by “actual” prices in the marketplace.

    (17) The “administered” prices of the world’s monopolies, and or, the world’s oligarchies: would not be the “asked” prices, were they not “validated” by (MVt), i.e., “validated” by the world’s Central Banks. Dr. Milton Friedman said it best: “inflation is always and everywhere a monetary phenomenon”.

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