Tuesday, April 8, 2008

A tiny defense on Taylor (fg)

What a mess these days when it comes to financial and macroeconomic outlooks for the USA . It was for the first time that FED chairman Ben Bernanke used the "r"- word - recession. In a previous post, I argued for the urgency of a recession. So, at least I should be happy about Bernanke's last statements.

As proponents of interest-rate rules, many economists were forced onto the defensive (see a post of amv on the New Consensus) since their academic advices how to deal with monetary policy seemed to be only good advices in times of fair weather. Today, the sea is rather stormy than calm, so these Taylor-type monetary-policy rules may not work porperly. Indeed, many critics claimed that such rules are the primer root and evil for the build-up of post-bubble financial turmoil.

In order to confirm or to reject these accusations, I calculated the Taylor rule for the U.S. accoring to which the FED should set interest rates in line with an inflation gap and output gap. If we assume that the inflation target is 1.9 percent and the FED uses the output gap concept of its own statisitic database (FED FRED), we can plot Taylor-implied and actual 3-month interest rate for the recent period. The result are shown in the following figure.

It is obvious that a FED that would have followed this "misspecified" Taylor rule would have not allowed to let the 3-month interest rate slump to below 1 percent. Indeed, the Taylor rule would have pruported to keep interest rate at levels of at least 4 percent! Therefore, it is the mistake of the FED itself rather than the academic-derived Taylor rule which produced the economic mess across the atlantic! Recent research of the OECD support these findings. It finds evidence suggesting that periods when short-term interest rates have been persistently and significantly below what Taylor rules would prescribe are correlated with increases in asset prices, especially as regards housing,