Friday, May 26, 2006

Phelps on the Taylor Rule

Ned Phelps has an op-ed in the yesterday's Financial Times arguing against the Federal Reserve adopting a Taylor rule for monetary policy (which I discussed in one of my last ec 10 lectures). An excerpt:

The rule advocated now, however, would set the short rate of interest. In the standard textbook rule, created by John Taylor, the Stanford University economist, in the 1980s, the real short rate (the money interest rate less the inflation rate) is set higher the greater is inflation, and lower the greater is unemployment. If perchance the inflation rate is at its "target" and unemployment is at the "natural unemployment rate", the real interest rate is to be set equal to the "natural interest rate" -- the real rate businesses could afford to pay if unemployment were at the natural unemployment rate. Mr Taylor took the natural rates to be constants.

Commitment to an interest rate rule would be dangerous because the product and labour markets could not rescue the economy from the consequences of an error in the rule. The natural interest rate is complicated to estimate. Should the natural interest rate be below the level the rule took it to be, no fall in prices and wages could restore unemployment to its natural rate: their fall would pull down the money supply with them, leaving no net restorative effect.

I think Ned exaggerates the danger here, for two reasons.

1. If the Fed overestimates the natural interest rate (essentially the constant in the Taylor rule), it will tighten monetary policy too much. The economy would respond with a lower rate of inflation, which in turn would induce the Fed to lower interest rates. In the end, overestimating the natural interest rate would mean a steady-state inflation rate below target. This is hardly a catastrophe. No one really knows if the optimal inflation rate is 0, 1, or 2 percent, so there is no big problem if we get a steady-state inflation rate a bit below the stated target. (A digression: Perhaps the optimal inflation rate is 3.14159265, which is why we always write inflation as π.)

2. Ned seems to be knocking down a strawman. I don't recall hearing anyone recommend a Taylor rule as a hard and fast rule to which the Federal Reserve would commit itself. The Taylor rule is more like a rule of thumb or a guideline for monetary policymakers, like the Pirate's code in "Pirates of the Caribbean: The Curse of the Black Pearl" (which, by the way, is a perfect movie if you have kids about 8 to 12 years old). As far as I know, no practical economist or central banker has proposed following a Taylor rule religiously.

Update: Brad DeLong helpfully find the quotation from the movie, where the villain Barbosa says:
First, your return to shore was not part of our negotiations nor our agreement, so I must do nothin'. And secondly, you must be a pirate for the Pirate's Code to apply, and you're not. And thirdly, the Code is more what you'd call "guidelines" than actual rules. Welcome aboard the Black Pearl, Miss Turner.