Thursday, September 2, 2010

Some Taylor wisdom (ls)

John Taylor dicusses if monetary policy needs a new paradigm or not. Find the paper here.

Here are the key statements:

"What are the key characteristics of the paradigm for monetary policy that were in place in the decades before the crisis? I would focus on these four: First, the short term interest rate (the federal funds rate in the United States) is determined by the forces of supply and demand in the money market. Second, the central bank (the Federal Reserve in the United States) adjusts the supply of money or reserves to bring about a desired target for the short term interest rate; there is thus a link between the quantity of money or reserves and the interest rate. Third, the central bank has a strategy, or rule, to adjust the interest rate depending on economic conditions: In general, the interest rate rises by a certain amount when inflation increases above its target and the interest rate falls when by a certain amount when the economy goes into a recession. Fourth,  to maintain its independence and focus on its main objectives of inflation control and  macroeconomic stability, the central bank does not allocate credit or engage in fiscal policy by adjusting the composition of its portfolio toward or away from certain firms or sectors."

 He's highly crtical in his assessment of the Fed's policy before the Lehman bankruptcy:

"My assessment is that the extraordinary measures taken in the period leading up to the panic did not work, and that some were harmful. [...] The Fed‘s on-again off-again bailout measures were thus an integral part of a generally unpredictable and confusing government response to the crisis which, in my view, led to panic."

He concludes that there is no need for a new paradigm in Monetary Policy. In his view, all we have to do is going back to a policy which follows the Taylor Rule. Indeed, an ex post analysis of the Fed's policy clearly shows that Fed Funds were significantly below the Taylor Rate 2002-2005 which probably has fostered the build-up of financial imbalances. Admittedly, his conclusion is appealing as it is a convenient one. But it neglects some recent research (e.g. by Adrian and Shin (2010)) on the endogenous nature of time-variyng risk-taking behaviour of financial intermediaries and its interdependence with the stance of monetary policy (see Borio/Zhu (2008)). So in my view, the question if central banks should explicitly engage in maintaining financial stability is still an open issue.    

In the end, Taylor argues in favour of the disputed DSGE models:

"It is easy to criticize the rational expectations/sticky price models by saying that they do not admit enough rigidities, or have only one interest rate, or do not have money in them. But we should not confuse useful simplified versions of models, which frequently boil down to only three equations, with more detailed models used for policy. By focusing on such smaller simplified models one can derive many useful theorems. For practical policy work those simplifying assumptions are relaxed. Many of the rational expectations/sticky price models [...] are more complex and have time varying risk premia in the term structure of interest rates, an exchange rate channel, and more than one country."