Re: The Taylor Rule: Response to Barkley and Henry Liu

["ÁÎ×Ó¹â HenryC.K.Liu ¹ù¤l¥ú" <hliu@xxxxxxxxxxxxxx>]

Basil Moore wrote:

> Henry
> The Fed cannot not set the short term interest rate, (unless it pegs the exchange
> rate, in which case another foreign CB. becomes the supplier of last resort.)

Agree.  The question then is whether the Fed should set ST rates by closed-door
intuitive wisdom, or by some explicit generally accepted formula based on economic
data and announced policy objectives, such as the Taylor Rule.  It seems that the
Taylor Rule reduces policy uncertainty by publicizing the rules of the game.

> As the residual monopoly supplier of liquidity to the system, the CB must supply
> funds to the banking system as demanded, if it is to preserve system liquidity.
> (This is also described as its role as "lender of last resort". It must also
> necessarily choose the rate that it will make funds available. Liquidity implies
> that security prices must be smoothed over time (so todays rate must not differ
> too much from yesterday's rate). As a result interest rates must also be smoothed
> over time. (If there are discontinuities, the assets are no longer liquid.)

Another way of looking at the problem is that liquidity is relative, and the degree
of liquidity is measurable by adjustments in asset price and/or money cost
(interest rate).

> The CB's policy reaction function describes how the CB chooses to vary rates in
> order to push the economy towards its policy goals, price stability and full
> employment. At present the Fed is operating under a false (incorrect) model of
> the economy. This states that the inflation rate is determined by the balance
> between AS and AD. To reduce expected inflation next quarter, it raises the ff
> rate today, in the expectation that this will reduce AD next quarter.
>
> But if the core inflation rate is governed not by the relation between AS & AD,
> but by the excess of money wage growth over average labour productivity growth,
> depressing AD will have the primary effect of depressing the level of effective
> demand and so real output, and only a weak indirect effect of depressing the rate
> of growth of money wages.  If there were an incomes policy in place (as is the
> case in Japan or Singapore), enforcing the relation that wage growth should not
> exceed average labour productiivity
> growth, the CB would be free to focus primarily on attaining full
> employment output.
>

True.  But Greenspan's view of the current US economy is that AD created by the
"wealth effect" is ahead of AS (goods and services "yet to be produced" was the
term he used).  And within the terms defined by Humphrey-Hawkins, the economy is
currently at structural zero unemployment (4%).

> Government deficit spending (fiscal policy) should not be resorted to to
> stimulate AD until the ST interest rate has been reduced to below 1 percent.
> This is incidently consistent with Keynes message at the end of the GT.

The debate being framed at this momment is focused on the proper level and vehicle
of surplus spending.  The options are: debt reduction; tax cuts or social spending
increases.  Greenspan opts for tax cuts, the Treasury practices debt reduction
(while creating "fiscal space") and some minority in Congress opts for increased
social spending.
The only spending increase Greenspan would endorse is expenditure for better and
faster (electronic) economic data collection and dissemination.

Keynes views policy for these economic conditions, rather uncommon in his time,
appear somewhat underdeveloped, at least to a lay person like myself.
I tend to agree with the growing number of economists who feel that tax reduction
is anti-expansionary, because as Paul Davision has pointed out, the function of
liquidity in the new economy is increasingly central.  An argument can be made
convincingly that debt, particularly risk free federal debt, enhances liquidity
which in term sustains growth.

In another post, I tried to draw attention to the SEC's coming examination on the
effect on liquidity by the proliferation of securities markets.  The SEC has
advanced 6 options for tying markets together to facilitate fairer trade, with a
60-day comment period.
The Senate Banking Committee is holding hearing starting next Monday (Feb. 28).
The most controversal option is the introduction of a virtual central market
screen  which is supported by big firms with institutional client and opposed by
retail firms with individual clients.
Greenspan told the Senate yesterday that the most efficient market, one that
present the narrowest spread between asking  and transaction prices would naturally
become the central market without government regulation.  While this is
theoretically true, exchanges have the administrative power to put obsticales in
the process, such as Rule 390 of the NYSE, subject to SEC repeal because it hinders
,e,ber firms from sending order elsewhere.  The debate, at its root is one of
power to direct the market, bewteen instituions and individual investors.  The two
group have very different decision amking dynamics.
The same reasoning and faith on the onimpotence of the market led Greenspan to
conclude that Treasury buybacks of 30-year bonds should have no structural impact
on the economy because if there is a need, the market will come up with an
alternative instrument to serve that need.  It is a very un-Keyneian view.

Henry C.K. Liu