When Guidance is Misguided, Seek New Guidance

July 16th, 2013 at 12:55 pm

Maybe not the hottest debate you’ve joined today, but here’s a bit more on the impact of using different Taylor rules, as per my mild disagreement with John Taylor himself this morning.  Again, one hesitates to argue with Whitney about how the cotton gin works, but it seems pretty clear that following Taylor’s 93 versions as he suggests on his blog would be a big mistake.

The figure below plots my calculation of the version of his rule that John posted this AM, using CBOs potential real GDP series to calculate the output gap, along Yellen’s version that I used earlier (slightly tweaked—see first link above), and the unemployment rate.

Note, as my former White House econo-colleague Jay Shambaugh pointed out to me, that if the Fed had been guided by the rule for which John now advocates, it would have raised the interest rate it controls to over 1% in the first quarter of 2010 when the unemployment rate was 9.8%!

The problem with his rule, as I suggested earlier (quoting Yellen), is that it down-weights the output gap: his 0.5 on the output gap versus 1, which Yellen uses and which Taylor himself suggested in a 1999 version on his rule.  That 0.5 worked well in tracking the actual Fed funds rate from the mid80s to the mid90s but it does less well after that and it’s been particularly off during the recession and its aftermath.

Rules of thumb like this are useful up until the point when they stop being useful.  A rule that says the Fed should have been raising the Fed funds rate in early 2010 should strike most folks who follow this as bad guidance in the spirit of counterproductive austerity.  Thankfully, the Fed did not make that mistake.

tay2

Source: BEA, CBO, BLS; *I use a slightly different version of Yellen’s Taylor rule, see first link above.

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2 comments in reply to "When Guidance is Misguided, Seek New Guidance"

  1. Tom in MN says:

    Didn’t the EU Central bank raise rates about 2010? Did they use the wrong rule? What does this plot look like for EU data?


  2. Secondary Sources: Commodity Prices, Taylor Rule, Bank of England - Real Time Economics - WSJ says:

    [...] –Taylor Rule: Jared Bernstein and John Taylor debate the use of the Taylor rule. “As my former White House econo-colleague Jay Shambaugh pointed out to me, that if the Fed had been guided by the rule for which John now advocates, it would have raised the interest rate it controls to over 1% in the first quarter of 2010 when the unemployment rate was 9.8%! The problem with his rule, as I suggested earlier (quoting Yellen), is that it down-weights the output gap: his 0.5 on the output gap versus 1, which Yellen uses and which Taylor himself suggested in a 1999 version on his rule. That 0.5 worked well in tracking the actual Fed funds rate from the mid80s to the mid90s but it does less well after that and it’s been particularly off during the recession and its aftermath.” [...]


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