Wednesday, September 17, 2014

Follow or Break the Rule?

Lars Christensen plots with recent data a version of the Taylor rule I proposed some years ago (published here).  I suggested this rule as an approximate description of Alan Greenspan's monetary policy in the 1990s. Here is Lars's plot:

Click on graphic to enlarge 
I based this rule (the green line) on data only from the 1990s, but notice that it does reasonably well until 2009.  The red line is the rule with parameters estimated from the later period.

Taken at face value, the rule suggests that it is time for the Fed to start raising the federal funds rate.  If you believe this rule was reasonably good during the period of the Great Moderation, does this mean the Fed should start tightening now, as the economy gets back to normal? 

Maybe, but not necessarily. There are two problems with interpreting such rules today.

The first and most obvious problem is that odd things have been happening in the labor market for the past several years. The unemployment rate (one of the right hand side variables in this rule) may not be a reliable indicator of slack.

The second and more subtle problem is the nagging issue of the zero lower bound.  For several years, the rule suggested a target federal funds rate deeply in the negative territory.  We are out of that range now, but should the past "errors" influence our target today?  An argument can be made that because the Fed kept the target rate "too high" for so long (that is, at zero rather than negative), it should commit itself now to keeping the target "too low" as compensation (that is, at zero for longer than the rule recommends).  By systematically doing so, the Fed encourages long rates to fall by more whenever the economy hits the zero lower bound. Such a policy might lead to greater stability than strict adherence to the rule as soon as we leave negative territory.

The time for the Fed to raise the target rate may be soon, but I don't think we are quite there.

Update: Ricardo Reis writes to me the following useful observation:

There is another (related) argument for not raising rates now to offset shortfalls in the past. It is not about the interest rate. It is about the price level, the ultimate goal of monetary policy and measure of its performance.

If you plot the PCE deflator, there is a clear shortfall relative to a 2% price-level target. A 2% price level target fits very well during Greenspan's time.  By the end of 2008, we were exactly on the 1992-target. But when I look at that plot starting in 2009 until the most recent data I see a gap.

A price-level target rule is optimal in normal times (Ball, Mankiw, and Reis) but is also an optimal policy in response to the dangers of the zero lower bound (Woodford). We have to catch up for the shortfall in the price level right now. And if you look at inflation expectations from surveys or markets, there seems to be no catch up expected, indicating that policy is still too tight.