An exit rule from John Taylor

John Taylor likes everything in monetary policy to be based on some rules. He has been a big critique of Fed’s policies which has not followed his Taylor rule and has intervened in financial markets in an adhoc manner. Then he has called most of Fed’s policies as Mondustrial – a monetary policy which is actually like an industrial policy favoring certain markets/sectors. He has been saying the various Fed programs should have been part of fiscal policy.

In his new paper he says Fed needs an exit rule to get out of its remaning programs (r’ber most of liquidity facilities have ended already).

An exit strategy to take the Fed to this monetary framework must focus on three things: (1) the federal funds rate, (2) the level of reserve balances (or the size of the Fed’s balance sheet), and (3) the composition of the Fed’s portfolio of assets. In order to achieve this goal the direction of change of all three is clear: The interest rate must rise above its current abnormally dedicated to the extraordinary programs such as TALF, MBS, and the Bear-Stearns-AIG facilities must be reduced. The timing and the amount by which these changes are made should depend on economic conditions.

Federal Reserve Board Chair Ben Bernanke (2009) has clearly described the instruments that are available to the Fed during an exit strategy, including paying interest on reserve balances, borrowing by the Fed to finance its extraordinary measures, and reducing reserve balances further by unwinding the extraordinary measures.

An exit strategy, however, is more than a list of instruments. It is a policy describing how the instruments will be adjusted over time until the monetary framework is reached. It is analogous to a policy rule for the interest rate in a monetary framework except that it also describes the level of reserves and the composition of the balance sheet. Hence, an exit strategy for monetary policy is essentially an  exit rule.

And what could the rule be?

One possible rule would link the FOMC’s decisions about the interest rate with its decisions about the level of reserves. In other words, when the FOMC decides to start increasing the federal funds rate target, it would also reduce reserve balances. One reasonable exit rule would reduce reserve balances by $100 billion for each 25 basis point increase in the federal funds rate. By the time the funds rate hits 2 percent, the level of reserves would be reduced by $800 billion and would likely be near the range needed for supply and demand equilibrium in the money market. The Trading Desk at the New York Fed would then be in a position to carry out the interest rate decisions of the FOMC as it has in the past, and the exit would be complete. Of course, at the start of this process, the FOMC is likely to need the assistance of increases in interest rates on reserves because of the high current level of reserves. And it might be wise to start reducing reserves by $100 billion or $200 billion before interest rates start to rise, because reserves are well above $800 billion now.

Where does the “$100 billion per quarter point” come from? We do not know much about the reserve-interest rate relationship, but $100bn per 25bps is close to what was observed when the Fed started increasing reserves in the fall of 2008. As shown in Figure 5 the funds rate fell from 2 percent to 0 percent as the Fed increased the supply of reserves by $800 billion.  Of course we do not know if this relationship will hold now with changed circumstances in the  banking sector, but it is a reasonable place to begin.

Interesting thought and quite a different one as well. +

Addendum:
You know I keep thinking if Taylor had been at Fed. Would he have run the monetary policy as he has been saying based on rules etc. It is a good theoretical idea but is it easy to implement?  Don Kohn has already looked at limitations of Taylor rule in real time policymaking.

 

 

One Response to “An exit rule from John Taylor”

  1. An exit rule from John Taylor « Mostly Economics Economic Finance news Says:

    […] Go here to see the original: An exit rule from John Taylor « Mostly Economics […]

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