For central bank watchers, it underlines the reality that despite the pretensions of being a highly mathematical science, central banks are making up their interest rate policy as they go along. This is probably not a surprise to experienced market participants, but it could be a shock to fresh graduates who believe the propaganda pumped out by mainstream economics faculties.
Relation To The Analysis In My BookChapter 2 of Interest Rate Cycles is titled "Central Bank View of Policy Rates," and leads up to the Taylor Rule, which ties together most of the theoretical concepts I discuss (inflation targeting, inflation expectations, the output gap, and the natural rate of interest). I also discuss why Taylor Rules are somewhat unworkable in practice -- a determined economist can always find a rule to match their predetermined view on interest rates. That is, a hawk will always be able to find a rule that suggests the policy rate should be higher than it is now (John Taylor being a prominent example).
I have heard the argument in a different context that central banking has advanced way beyond this, and thinking has been revolutionised. Since most of my writing aims to be at an "introductory" level (although aimed at people with some knowledge of business cycle economics), I would argue that we need to start with the basics. Furthermore, the more "advanced" ideas just involve adding epicycles to existing DSGE models, and the core criticisms raised about Taylor Rules are just as applicable to things like "optimal control rules" (link to article explaining why I chortle when I write about them).
Any reaction function is going to be hostage to model parameters, particularly "sophisticated" ones like optimal control rules. (Their instability is why engineers abandoned optimal control rules. Simpler control laws -- which resemble the Taylor rule -- are more robust to model specification error.)
If The Natural Rate Moves Around At Random, Policy Is DiscretionaryTaylor and Wieland (page 11):
In any case this is a controversial and debatable issue, deserving a lot of research. If one can adjust the intercept term (that is, RR* [the equilibrium real natural rate - BR]) in a policy rule in a purely discretionary way, then it is not a rule at all any more. It’s purely discretion. Sharp changes in the equilibrium interest rate need to be treated very carefully.Why are estimation methods for the natural rate going to miss? The means of estimating them omit many factors (as highlighted by Taylor and Wieland), but particularly the operation of the automatic stabilisers of fiscal policy (which they ignore). I discuss this theoretical point in an earlier article. To summarise, since the automatic stabilisers and monetary policy are correlated, while fiscal policy is banished from DSGE models, estimation techniques that assume the DSGE model dynamics are correct will attribute too much importance to interest rate policy. This means that the estimated natural rate always ends up being close to the actual policy rate -- no matter what the policy rate is.
From John Taylor's perspective, discretionary policy is a deal-breaker. Like many advocates of free markets, his research programme is built around the belief that government policy needs to be hemmed in by policy rules. Although some free market advocates want to revert back to the mythical rules-based Eden of a Gold Standard, Taylor's preference is for rule-based interest rate policy. (Milton Friedman's belief in another rule-based policy -- targeting money supply growth -- led to Monetarism jumping the shark in the early 1980s.)
Even if one thinks that rules-based policy is a disastrous dead end (I do), the problem for DSGE macro is that it is built entirely around the concept. The solution to "inter-temporal optimisations" requires that the path of the policy rate be set by a rule of some sort, otherwise there is no way of finding a solution. One of the selling points of DSGE macro was that it provided such rules, even though it provides almost no useful information for how to set the policy rate at an individual meeting. However, if policy is entirely discretionary, why exactly are we forced to do all this pseudo-mathematics?
Yelping about the zero lower bound, or optimal control rules, does nothing about this critique. Since we have no idea what the "true" natural rate is, we have no idea whether any of that theory is applicable.
Article Misses The Point Of Monetary PolicyThe article argues that the natural rate of interest has not really moved, rather that estimation procedures are missing two variables. (Neither of them are the correct variable, which is fiscal policy.)
- The variable "x* could represent a variety of influences on real GDP from regulations that negatively affect investment to tax policy that negatively affects consumption." (Incidentally, John Taylor has a new book out explaining how regulatory policy is strangling economic growth.)
- "d* is a possible deviation from the policy implied by the [Taylor] rule".
The effect of the first variable x* can be easily dealt with. The article states "With equation (1’), if one finds that y-y* is lower than the prediction P(y-y*), then the implication is not necessarily that the estimate of r* is too high and must be lowered. Now there is the possibility that x* is too low and must be raised. [emphasis mine]"
This is not how monetary policy works. Within the reaction function for the policy rate, there is no output corresponding to "regulatory policy." In fact, such changes are outside the mandate of the Federal Reserve (unless they believe that zealous enforcement of banking regulations by the Fed is what has caused disappointing growth, which is utterly implausible).
The Taylor rule just specifies the policy rate, and the natural rate of interest is a model-dependent variable which summarises the effect of interest rates on the economy based on the estimated economic structure. Since the Fed has no control over x*, it has no choice but to set policy to counteract it. It cannot set rates based on the United States economy being at some utopian equilibrium, it has to take into account how the economy is actually operating,
The d* variable is an extremely puzzling addition to the Taylor Rule. It essentially says that if the policy rate deviates from the predicted rate, then (r* + d*) will move towards the (real) policy rate. Since these two variables are essentially inseparable, we end up with a term (r* + d*) that always drifts towards the real policy rate. It is equivalent to saying that the natural (real) rate of interest is the moving average of the (real) policy rate. This is a specification that has the implication that the natural rate of interest has essentially no predictive power. (No matter where the actual policy rate is set, the term (r* + d*) will end up where it is, which means the policy rate setting has no long-term effect on the economy.) In which case, why do we even care where the central bank sets the interest rate?
Concluding RemarksMainstream economics is built upon unmeasured variables, and has drifted towards being entirely unfalsifiable. Until this reality is taken seriously, it will consist of pointless debates such as we see in this Taylor and Wieland paper.
(c) Brian Romanchuk 2016