More Monetary Policy Uncertainty

The Fed’s announcements yesterday increase monetary policy uncertainty in two fundamental ways.

Quantitative Easing on Steroids?

First, the new quantitative easing announcement implies a gigantic increase in the size of the Fed’s balance sheet and thus effectively an amplification of the policy risks and uncertainty which I have discussed, for example, in this oped with George Shultz and other colleagues in September. The Fed now plans to purchase $85 billion a month of longer-term Treasury and mortgage backed securities until there is substantial improvement in the labor market, which requires a completely unprecedented increase in reserve balances as illustrated in this chart.

The chart shows reserve balances held by banks at the Fed. These are used to finance the large scale asset purchases. The chart assumes that substantial labor market improvement is defined by the 6.5% unemployment rate the Fed is using to assess when to raise interest rates. Thus, assuming the central tendency forecast of the FOMC, the announced buying spree will bring reserve balances to about $4 trillion in mid-2005. The risk is two-sided. If the Fed does not draw down reserves fast enough during a future exit, then it will cause inflation. If it draws them down too fast, then it will cause another recession.

Another Great Deviation On the Way?

Second, the new state-based zero interest rate policy will lead to interest rates far below levels that created good performance in the past and close to levels that eventually created high unemployment. In an effort to explain the new policy during the press conference yesterday, Ben Bernanke referred to the Taylor rule, saying:

“So it’s really more like a reaction function or a Taylor rule if you will. I don’t want–I’m–I’ll get it–I’m ready to get the phone call from John Taylor. It is not a Taylor rule but it has the same feature that it relates policy to observables in the economy such as unemployment and inflation.”

In fact, the Fed’s new state-based policy calls for the federal funds rate to stay way below the Taylor rule, as did the calendar-based policy. You can see this deviation in two ways: a chart or some algebra.

Consider the following chart (an updated version of a chart due to Bob DiClemente) which I used in my talk last month at the Cato Institute. The red line shows the interest rate according to the Taylor rule with the future values based on FOMC forecasts for inflation and growth. The zero interest rate forecasts by most FOMC members (shown by the dots) for mid-2005—a time when, they forecast, the unemployment rate will be about 6.5 percent—are more than 2 percentage points below the Taylor rule. (The gray line is a version of the Taylor rule used by Janet Yellen and others at the Fed.)

You can also plug in values into the Taylor rule:

R = 2 + π + 0.5(π – 2) + 0.5Y

where R is the federal funds rate, π is the inflation rate, and Y is the GDP gap.

Assume that Y = -2(U-5.5) where U is the unemployment rate and 5.5 is the long-term unemployment rate implied by FOMC projections. Then when the unemployment rate is 6.5% and the inflation rate is 2%, the interest rate is 2+2 -1 = 3%. So there is a 3 percent deviation.

The last time the deviation between the Taylor rule and the actual rate was this large was in the “too low for too long” period of 2003-2005 which helped create the boom which led to the bust, the financial crisis, and the recession. High unemployment was the result. The deviation was also this large during the economic mess of the 1970s. High unemployment, along with high inflation, was the result then too.

Comparison with Larry Ball’s Calculations

Larry Ball did a very similar algebraic calculation with similar conclusions about the difference between the Fed’s future policy rate and the Taylor rule, which Greg Mankiw posted on his blog earlier today.

However, Larry finds that the actual interest rate was not below the Taylor rule in the 2003 period. This result is contrary to empirical research by George Kahnme and others. The difference may be due to Larry’s using an implied coefficient on the output gap which is larger than .5. Nevertheless, the deviation Larry uncovers is much larger than in the 1970s, which in itself raises risks.

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

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