Rules and Wisdom: Choking Us?
daniel j molitor
7/19/2012 01:28:00 PM
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Setting aside the argument over whether this is actually the useful takeaway Taylor and Cochrane proclaim it to be, it's interesting to suppose what this actually might entail for central banking policy. Taylor's namesake rule contains but "one normative target—a 2 percent inflation rate," which ignores any short-term output or employment deviation in favor of a blind pursuit of price stability. The way I see it, this helps rentiers more than it does the economy as a whole, especially when low inflation is exacerbating the real burden of a big debt overhang -- but I digress.
Even accepting that 2% is a reasonable goal as the sole target of monetary policy, the Fed should be easing on those grounds alone, considering the copious data indicating low and slowing inflation. Since we're at the lower bound, this means more QE or unconventional tricks (like charging interest on reserves or setting caps on interest paid on reserves). This seems unlikely: while there has been a steady stream of rumors about a third round of QE, we hear nothing approaching serious consideration of easing from the Fed.
Sadly, the more we hear from the Fed, the more they seem to exhibit this weird obsession with credibility, which I find tragically misplaced. While Bernanke seems to think aiding a US recovery would endanger the "hard-won credibility" of his institution, I think the greater threat to the Fed's institutional prestige is allowing the recovery to proceed so lethargically. The Fed has stepped in time and countless time again to mitigate economic fallout from financial collapses; is Bernanke really okay presiding over the first Depression since the 30's? Even according to Freshwater types like Cochrane and Taylor, the best policy to achieve credibility is a rule-based policy, which, any way you look at it, is saying ease now! By not easing when the rule is saying we should, we are engaging in passive tightening, which is just as contractionary as active tightening in this case. And I would just love to hear the arguments for contractionary policy.
Revisiting the price-stability target: as I hinted at, I think targeting inflation alone is a lousy way for a central bank to conduct itself. We can see how the ECB's insistence on low inflation has aggravated an already ruinous situation in Europe, including a disastrous decision to actually raise interest rates last year. Nominal GDP targeting has gained some traction from various angles (including Tyler Cowen and Paul Krugman, among others) as a reasonable alternative to inflation-targeting, and is one I feel holds some real promise going forward, hopefully with the next generation of economists. And NGDP targeting would prescribe a totally unambiguous way forward from the disinflationary low-employment rut we see today: ease now and ease hard. No discretion necessary.
The paper includes both a boilerplate RBC model and a more interesting New Keynesian model. He uses the later to argue that there exists a feasible (but not simple) path for tax rates that makes spending cuts expansionary. My first impressions are this: first, he reached the opposite result of a very similar model I've seen, so I think there is some phony business going on in how the taxes are modeled there. Second, this seems to be a rather dubious implication of the model that relies too much on rational expectation/riccardian equivalence, as well as calibrations that haven't been explicitly estimated in the context of his model specifically.