We got it all wrong.-
I came across some old reads regarding the Taylor rule for the monetary policy imposed rate of interest -the fed funds rate (not to be confused with the Wicksellian, natural rate). As most economists would have done, I immediately engaged in a quick mental check of the implied rate applicable in our actual economic conditions -both for the Euroarea and the US. You can think for yourself, it is pretty straightforward to calculate -if you can trust the published inflation rate, and figure out the output gap with some sense of accuracy (I suggest you better just trust the official liestatistics).
And then, I began to think about its components. It was built for the US, and, as a consequence of the dual mandate, it sports two weighted structural components. The inflation weighting, arbitrarily set at 0.5%, and the output gap coefficient also at 0,5% (in the original formula). Both figures stink of a Solomonic compromise between the two mandates. No scientific backing is to be found for those equal weightings. His guess is as good as mine -or any other.
What’s more, the math also includes an “out of the blue” implicit inflation target at two per cent, and a Wicksellian-estimated long term equilibrium real interest rate of 2%. Take all those subjective factors in, put some faith to play (of the religious kind), and assume they are right. Now, that, and no other, is the run of the mill amount of predefinitions that apply even for a relatively simple (and brilliant) formula. Just imagine what the formula would be like with a DSGE model like math. No matter how good the formula is, the estimated pre-introduced parameters are bound to be wrong. We are following the wrong economic manuals.
Do you really think that any of us can get those parameters consistently right -much less so the mediocre FOMC? Come on! We have to be realistic. Give me the formula and the chance to chair the Fed, and I will provide you with some decent arguments for a Taylor rule rate calculation with a double result. And a spread between the two numbers in hundredths of basis points! They are really playing “God”. And they like it so much… They feel powerful. It’s like pretending to be Superman. Some say power is a great aphrodisiac. Maybe. I have to give it a try someday.
Once you decide that monetary policy plays not only a role, but even allows for a dual mandate, it is all a downhill walk to arrogance. Planetary arrogance. The equation (or its most basic principles), is also applicable for China, Japan, or the Eurozone, provided we can convert it into a somewhat more sophisticated algorithm. Why only two mandates?
The ECB may not have an explicit dual mandate, but de facto, and viciously late, it always goes all the way to “whatever it takes”. At least ever since we lost good old fashioned Jean Claude Trichet. Talk about crappy dual mandates like in the US. You want to be generous and open minded. Dragui and Co feel they have a spherical multipolar mandate to do, whatever it takes, for any end that they feel might be desirable. It gets better yet with Chinese monetary policy. When it comes to the Chinese we really need a half a dozen formulas. Monetary policy, credit growth, child birth policy or fiscal profligacy are all levers to fine tune the economic engine. And I am missing some more. Fine tuning? Or gruesome manipulation?
Maybe Taylor should work on his math and take climate change, social distress, and immigration policy -or any other relevant issues that suit the politburó, as new elements for the formula. He can give them equal weighting (following up on his previous Solomonic strain) or opt otherwise. Maybe he can give climate change an 80% weighting. Or he might even enjoy introducing some ideological factor with a relevant weighting to please the Chinese communist party. Does it matter?
Conventional wisdom has it that monetary policy really solves it all. It’s just magic. People are beginning to whisper the miraculous result of joint immunotherapy and NIRP in the advanced treatment of cancer metastases. Can you imagine that? Once you do think that monetary policy is a tool for anything other than stabilizing the value of our medium of exchange (money), you are booked into Hotel California. You can never leave. You will need more and more of the drug. And while you are still booked in, why not try to use the hotel drug saloon-spa to bulge investment, lower unemployment, or combat corruption or climate change with it. The whole set up smacks of arrogance and insane reasoning. And yet nobody dares question this axiom.
If you manage money, and you are serious about it, you just have to double-check all the economic conventions constantly. This is a rapidly changing world, and you’d better see risks before others do. On this particular rule, and the implied wisdom underlining it, the validity of the recipe is crucial. Right or wrong, I like to think, and challenge conventional wisdom in key axioms. Some of us are perpetual dissidents in whatever area of science we happen to be involved. Actually, believe me, it is very tiring to question daily what everybody else takes for granted.
The Taylor rule is like the ten commandments list. Everybody is wholeheartedly confident that it is the work of a genius. In fact I have nothing but praise for the maths in the formula. My discrepancies go much deeper. Why do we need a formula?
Taylor’s algo has certainly helped provide a coherent explanation for the interest rate levels set by the FOMC since Volcker -up to roughly 2010. Alan and Ben adore it, so I have to be extra-careful about my critique. Right now, it is suggesting no tightening for the USD -that most likely wouldn’t last long because of instantaneous further deterioration of the real economy. To be very honest, I really don’t care. And anyway, as of late they are actually ignoring it. Interest rates have to go up, but not because of Taylor rule numbers, inflation expectations, or taming the cycle. And the best we will get, if we do get it, is a “one and done” job.
The issue is not if this is the applicable formula or we should use any other. It is not about dual or even single mandates. The issue is if monetary (and fiscal) policy guided economic activity is the way to go, or a self-perpetuating delusion. Continue reading