To review, I recently suggested that based on Janet Yellen’s version of the Taylor rule (really, my slightly tweaked version of her version), the Fed should be following the accommodative stance suggested by Bernanke last week as opposed to the slightly more hawkish view he sorta kinda espoused the week before.
John Taylor, he who derived the rule in the first place, shot back saying that in fact, his 1993 version of the rule recommends that the Fed funds rate (ffr) should be positive right now. I responded by saying, in so many words, that Taylor ’99 is more appropriate right now that Taylor ’93, the difference being that John’s later version upweights the output gap which seems important today.
A few further points to consider:
–In the most recent quarter, even Taylor ’93 would set the ffr at just about zero (-0.1); moreover, the recent deceleration of PCE inflation and the still large GDP output gap (as measured by CBO’s potential GDP series) have driven the output of the ’93 equation from a recommended ffr of around 2% in the second half of 2011 to one of about zero today.
–It seems awfully clear that the ’93 rule was too hawkish back in 2010-11, suggesting an ffr of around 1% in the first half of 2010 when unemployment averaged 9.7%.
–As numerous analysts have noted, the Taylor rule may provide less useful guidance in unusual monetary times, like when the ffr us up against the zero lower bound, and when asset purchases and forward guidance are also affecting interest rates, growth, and expectations.
–Finally, and this seems quite important to me, the fact that the Federal Reserve itself has consistently had to mark down their GDP forecasts suggests that their own internal expectations have been too sunny.
The figure below shows different vintages of the Fed’s forecast for 2013 GDP growth, starting in January 2011, when they thought growth this year would be 4%. Most recently, with half the year left to go, they’ve settled in on 2.5% (q4/q4).
In fact, Goldman Sachs researchers think 2013 real GDP growth will come in at 1.8%; Mark Zandi at economy.com forecasts 2.2%; the IMF says 2%–and I suspect they’re more likely to be correct than the Fed.
If I were on the FOMC, this too—along with all the other points above, not to mention slowing inflation and persistent, large output gaps—would lead me to give more weight to the output gap and to err on the side of caution re moving off the current accommodative stance.
Source: Federal Reserve