Stanford Professor John Taylor presented another very interesting paper at the Jackson Fed conference.
Among Professor Taylor’s many lasting contributions to macroeconomics is development of the Taylor Rule. As with many issues in macroeconomics, Ben Bernanke’s exposition (hat tip: David Altig) is as fine as any:
In its most basic version the Taylor rule is an equation that relates the current setting of the federal funds rate to two variables: the level of the output gap (the deviation of output from its full-employment level) and the difference between the inflation rate and the policy committee’s preferred inflation rate. Like most feedback policies, the Taylor rule instructs policymakers to “lean against the wind”; for example, when output is above its potential or inflation is above the target, the Taylor rule implies that the federal funds rate should be set above its average level, which (all else being equal) should slow the economy and bring output or inflation back toward the desired range.
A well-known research paper by Richard Clarida, Jordi Gali, and Mark Gertler is one among many that suggested that much of the reduced volatility of U.S. GDP since the mid-1980s might be attributed to an improved tendency of the Fed to follow such a rule. In particular, the argument is that since 1982, the Fed was able to raise the nominal interest rate faster than increases in inflation to help stabilize the economy. In his remarks in Jackson Hole, Professor Taylor noted that housing investment in particular seemed to be more stable after 1982, perhaps due to precisely this improvement in monetary policy.
However, Taylor was concerned that the Fed deviated from this favorable record during the 2003-2005 period, in that it increased the fed funds rate more slowly than his rule would have suggested. I remember (well, Google helped me find it exactly) that Dave Altig had commented on this two years ago:
In his paper at Jackson Hole on Saturday, Professor Taylor considered two paths for the fed funds rate, the actual path (shown as the solid line below) and a counterfactual path (dashed) that Taylor believes would have been closer to the optimal response.
Professor Taylor then estimated a simple model to try to predict housing starts on the basis of past values of interest rates. The solid line in the following diagram displays the actual path for housing starts, which exhibited a phenomenal boom followed by even more dramatic bust. The figure also displays, in the higher, short-dashed curve, housing starts as they would have been predicted by the model using the actual time path chosen for the funds rate by the Federal Reserve. This predicted path is able to account for a boom and subsequent bust in housing, though both are more modest than what was seen in the actual data. Taylor then conducted a counterfactual simulation for what the model would have predicted had the fed funds rate been raised more quickly (the lower long-dashed curve). These counterfactual simulations suggest that, if instead of doing what it did during 2002-2005, the Fed had instead simply adhered to the Taylor Rule, the result would have mitigated both much of the boom in housing starts as well as the subsequent bust.
There was a lot of discussion at the conference about whether the Fed should have leaned against the accelerating real estate prices during 2003-2005. Taylor’s simulations suggest that the Fed should perhaps have been thinking of itself as one important cause of that phenomenon in the first place.