Monday, January 11, 2010
Around here, with only a few exceptions, there is nothing more exciting than a public spat between two economists and when it's the world's most important economist in Fed Chief Ben Bernanke and Stanford University Professor John Taylor, co-creator of one of the most hallowed rules in economics - The Taylor Rule - it just can't get any better than this.
In an opinion piece in today's Wall Street Journal, Taylor is clearly seething at the liberties taken by the Fed chief in a speech a week ago that used the Taylor Rule in support of arguments that interest rates were not "too low, for too long" a few years back.
My critique, which I presented at the annual Jackson Hole conference for central bankers in the summer of 2007, is based on the simple observation that the Fed's target for the federal-funds interest rate was well below what the Taylor rule would call for in 2002-2005. By this measure the interest rate was too low for too long, reducing borrowing costs and accelerating the housing boom.Now, keep in mind that economists are normally mild-mannered fellows, so, you don't expect to see things like ALL-CAPS or profanity (particularly when WSJ editors are involved), so this is about as extreme as you can imagine ... there were likely little wisps of steam coming out of Taylor's ears as he finished that last sentence above, and understandably so.
In his speech, Mr. Bernanke's main response to this critique was to propose alternatives to the standard Taylor rule—and then to use the alternatives to rationalize the Fed's policy in 2002-2005.
Collecting himself as necessary, Taylor moves on to the specifics of his rebuttal, which, even for a non-economist seem to make good sense:
In one alternative, which addresses what he describes as his "most significant concern regarding the use of the standard Taylor rule," he put the Fed's forecasts of future inflation into the Taylor rule rather than actual measured inflation. Because the Fed's inflation forecasts were lower than current inflation during this period, this alternative obviously gives a lower target interest rate and seems to justify the Fed's decisions at the time.If this were one construction worker reprimanding another it would surely be an expletive-laced, face-jutting-out-over-the-top-of-the-chest, top-of-the-lungs scolding of that other construction worker's failings, but, since these two are economists, you get critiques such as "no empirical evidence" instead.
There are several problems with this procedure. First, the Fed's forecasts of inflation were too low. Inflation increased rather than decreased in 2002-2005. Second, as shown by economists Athanasios Orphanides and Volker Wieland, who previously served on the Federal Reserve Board staff, if one uses the average of private sector inflation forecasts rather than the Fed's forecasts, the interest rate would still have been judged as too low for too long.
Third, Mr. Bernanke cites no empirical evidence that his alternative to the Taylor rule improves central-bank performance. He mentions that forecasts avoid overreacting to temporary movements in inflation—but so does the simple averaging of broad price indices as in the Taylor rule. Indeed, his alternative is not well defined because one does not know whose forecasts to use. Moreover, the appropriate response to an increase in actual inflation would be different from the appropriate response to an increase in forecast inflation.
Taylor is much more peeved about what Fed chief Ben Bernanke did last week than the casual reader might glean from this commentary. Then again, he is an economist, and it is not at all clear that economists have emotions like the rest of us.