Archive for January 13th, 2010

John Taylor responds to Ben Bernanke

January 13, 2010

Bernanke had recently defended Fed’s loose monetary policy before the crisis. He mainly looked at Taylor rules and specifically John  Taylor’s paper in 2007 which said Fed policies were too loose which led to the bubble. Bernanke showed the policies were not loose if different forms of Taylor rules were used.

A response from Taylor was expected. He first responded on his blog but did not have much time then and said would respond in detail soon. In a recent WSJ article he offers a more detailed explanation:

Federal Reserve Board Chairman Ben Bernanke spent most of his speech to the American Economic Association on Jan. 3 responding to the critique that easy monetary policy during 2002-2005 contributed to the housing boom, to excessive risk taking, and thereby to the financial crisis.

Many have expressed the view that monetary policy was too easy during this period. They include editorial writers in this newspaper, former Fed policy makers such as Timothy Geithner (now the secretary of the Treasury), and academics such as business-cycle analyst Robert J. Gordon of Northwestern. But Mr. Bernanke focused most of his time on my research, especially on a well-known policy benchmark commonly known as the Taylor rule.

Taylor defends his analysis on multiple grounds:

First, the Fed’s forecasts of inflation were too low. Inflation increased rather than decreased in 2002-2005. Second, as shown by economists Athanasios Orphanides and Volker Wieland, who previously served on the Federal Reserve Board staff, if one uses the average of private sector inflation forecasts rather than the Fed’s forecasts, the interest rate would still have been judged as too low for too long.

Third, Mr. Bernanke cites no empirical evidence that his alternative to the Taylor rule improves central-bank performance. He mentions that forecasts avoid overreacting to temporary movements in inflation—but so does the simple averaging of broad price indices as in the Taylor rule. Indeed, his alternative is not well defined because one does not know whose forecasts to use. Moreover, the appropriate response to an increase in actual inflation would be different from the appropriate response to an increase in forecast inflation.

There are other questionable points. Mr. Bernanke’s speech raises doubts about the Taylor rule by showing that another version of the rule would have called for very high interest rates in the first few months of 2008. But using the standard Taylor rule, with the GDP price index as the measure of inflation, interest rates would not be so high, as I testified at the House Financial Services Committee in February 2008.

Mr. Bernanke also said that international evidence does not show a statistically significant relationship between policy deviations from the Taylor rule and housing booms. But his speech does not mention that research at the Organization for Economic Cooperation and Development in March 2008 did find a statistically significant relationship.

Mr. Bernanke claimed that “Economists who have investigated the issue have generally found that, based on historical relationships, only a small portion of the increase in house prices earlier this decade can be attributed to the stance of U.S. monetary policy.” But two of the economists he cites—Frank Smets, director of research at the European Central Bank, and his colleague Marek Jarocinski—reported in the July/August issue of the St. Louis Fed Review that “evidence that monetary policy has significant effects on housing investment and house prices and that easy monetary policy designed to stave off perceived risks of deflation in 2002-04 has contributed to the boom in the housing market in 2004 and 2005.”

Hmmm.  Taylor also provides more links on his other blogpost

Bernanke will not really respond as he is in policymaking. So there will be no real fireworks between the two.

I think both are right in their own way as the main problem is measurement using Taylor rules. One main concept in Taylor rules is calculating output gap which is so difficult to compute. Even forecasting inflation is anything but simple as it comes from both Bernanke and Taylor. It depends on which model, measure of inflation (CPI, GDP deflator etc) you use.

But it is exciting stuff. These discussions help bring out nitty gritties of economic concepts. Implementing the economic concept is where the challenge is.

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