By David Papell
In his speech at the American Economic Association meetings on Monetary Policy and the Housing Bubble, Fed Chair Ben Bernanke argued that, in contrast to the critique by John Taylor, monetary policy was neither too stimulative during 2002-2006 nor caused the housing bubble. In this post, I focus on the first part of his argument.
Bernanke’s main point is that, using the Taylor rule as a benchmark, monetary policy during this period was only too stimulative if contemporaneous values of inflation and the output gap, rather than forecast values of the variables, are used for the evaluation. This is shown in the figure below, which reproduces Slide 4 from his speech. The solid line is the target value for the federal funds interest rate. The long-dashed line is the interest rate prescribed by a rule with Taylor’s original coefficients, so that the interest rate equals 1.0 + 1.5 * inflation + 0.5 * output gap, using headline CPI inflation as currently measured. The short-dashed line is the prescribed interest rate using the forecast of core PCE inflation as measured in real time. The gap between the implied Taylor rule interest rate and the actual target for the federal funds rate is much larger with currently measured than with forecasted inflation, leading to the conclusion that, since monetary policy evaluation should be conducted using forecasted inflation, Taylor’s critique is refuted and monetary policy following the 2001 recession appears to have been reasonably appropriate.
This is an apples-to-oranges comparison. Bernanke is making a contrast between Taylor rule prescriptions with currently observed and forecasted inflation using one inflation measure for the former and another inflation measure for the latter. In order to make an apples-to-apples comparison, the figure below depicts the target federal funds rate, the prescribed federal funds rate using CPI inflation, and the prescribed federal funds rate using core PCE inflation, both measured using real-time data. The gap between the implied Taylor rule interest rate and the actual target for the federal funds rate is much larger with headline CPI than with core PCE inflation. Since neither measure uses inflation forecasts, it is clear that Bernanke’s results depend on using two different measures of inflation, not on using currently observed versus forecasted inflation.
Bernanke’s second point is that proponents of the standard Taylor rule using current inflation values would have recommended that the FOMC raise the policy rate to a range of 7 to 8 percent through the first three quarters of 2008 — a policy decision that would not have received much support among monetary specialists. The reason for this unappealing result is that record-setting oil prices in the first two quarters of 2008 caused headline CPI inflation, but not core PCE inflation, to spike sharply upward, not because the standard Taylor rule doesn’t use forecasted values. Moreover, describing a Taylor rule using CPI inflation as standard is misleading and ignores the fact that the original Taylor rule paper, as well as much subsequent research, uses the GDP deflator as the inflation measure. The figure below depicts the target federal funds rate and the prescribed federal funds rate using real-time GDP deflator inflation. Two points are evident from the three figures. First, the gap between the implied Taylor rule interest rate and the actual target for the federal funds rate is larger for GDP deflator inflation than for core PCE inflation, although smaller than for headline CPI inflation. Second, the Taylor rule prescriptions for 2008 are similar for GDP deflator and core PCE inflation, with both implying much lower interest rates than are implied by the Taylor rule using CPI inflation.
In his speech, Bernanke ascribed two results — that Fed policy was too stimulative following the 2001 recession and that the policy rate should have been between 7 and 8 percent in the first three quarters of 2008 — to the use of a “standard” Taylor rule with contemporaneous, rather than forecasted, inflation. In fact, both results come from using headline CPI versus core PCE inflation– not from using contemporaneous versus forecasted inflation. In addition, Taylor’s original paper used contemporaneous GDP deflator inflation. With that measure, Fed policy was still too stimulative during 2003-2005, but the implied policy rate in the first three quarters of 2008 was between 3 and 4 percent, not between 7 and 8 percent.
This post written by David Papell.