Could the ‘Taylor Rule’ Have Prevented the Housing Bubble?

What was merely an academic exercise has become an applied tool for central banks. Just see whether your policy is in line with the T-rule and all shall be well.

Mateusz Machaj discusses the limitations of the rule and why we should avoid the hype around it.

Thomas Woods: The Taylor rule has been cited for so long by so many people who describe themselves as free-market economists that it has become more or less the conventional wisdom that the Taylor rule is a good guide for the central bank in formulating monetary policy. Let’s start off by explaining who Taylor is and what the Taylor rule says, in a way that’s understandable to the layman.

Mateusz Machaj: Well, John Taylor started working on monetary policy in the early ’90s. He published a paper describing what the Federal Reserve System was doing in terms of monetary policy in the ’80s, and he apparently discovered that the Federal Reserve was following some version of the monetary policy rule, a sort of fixed rule. It was not probably fixed like the famous Friedman rule. It was short lived, but still it was a general rule for monetary policy. And it was a purely descriptive paper. And then after a few years, suddenly, from this purely descriptive paper in the literature we have a flourishing of the concept of the Taylor rule, based on this paper as if it were some normative proposition of how to conduct a correct monetary policy, whereas it was just a description of what was done in the ’80s. And that’s how we got into the whole Taylor rule thing.

Also, in the early 21st century, various versions of the Taylor rule were proposed for monetary policy. Unfortunately, they failed, but Taylor himself, in 2009, after the Great Recession started, published a paper arguing that the Federal Reserve System was not following his rule, and that was the reason for the real estate boom, and that was the main factor for the recession. And therefore, from his description of various, let’s say, mildly pro-market people with a sort of Friedmanite sentiment for having government rules that are supposed to constrain the government, we have the sentiment somehow about following the Taylor rule that is constraining government in some way by proposing a form of monetary constitution or something like that in order to stabilize the economy. But of course, the main problem is that this rule itself is vague, it’s unclear, and it actually opens the door for destructive monetary policy because it’s still a monetary policy performed by the government, by a government agency.

TW: Right, so that, of course, is going to be the ultimate problem with it. But one of the points you’re making in the paper is that even if we accept the idea that the Taylor rule is a good policy, even if we accept the idea that we should have some rule that overrides what would spontaneously occur on the market, nevertheless there are practical problems even with implementing the Taylor rule, one of them being the problem of figuring out which data ought to be used. Depending on which numbers you use, you wind up getting a different Taylor rule. Before we get into that, what exactly is the Taylor rule saying the central bank should do? He is saying, if you would listen to my Taylor rule, interest rates would have been higher, and you wouldn’t have had this housing bubble. So what does the rule tell the central bank it should do with interest rates?

MM: The Taylor rule itself is just an equation, and the equation can have many different forms. To make it as simple as possible to our listeners, the equation says that you are supposed to arrive at a certain level of interest rates set by the central bank based on two other main variables: price inflation and the so-called output gap. Apart from that, we have some additional coefficients that we put in the equation, and we arrive at the final number. The higher the inflation rate, of course, the higher the recommended interest rate by the central bank, and the bigger the output gap — that is, the further away we are from, let’s say, potential production, potential output — then the interest rates are supposed to be lower in order to boost spending and boost the economy and reach the potential level. Now, there are two main problems with this approach, one group with mainstream objections to the rule itself, and the other group employ Austrian objections — well, the mainstream objection would be that you have various problems with measurements, as you mentioned. That is, how you measure price inflation, and how you measure the so-called output gap. And there are lots of articles written in the mainstream literature actually arguing that there are serious problems with measuring the so-called potential output, the potential production. Some mainstream economists argue that we should get rid of it and forget it about it, because various ways of measuring this whole potential output are actually so vague that we should downplay it completely and forget about it.

He says Taylor rule is associated with so called free market principles but is just the opposite..

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