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

[Basil Moore <bmoore@xxxxxxxxxxxxxxxxx>]

Henry

As I understand the Taylor Rule, it is intended to be a description, by an
outsider,(the economist or policy analyst) of the Fed.'s discretionary
monetary policy behaviour, i.e. its reaction function: how it adjusts the
short term interest rate (FF's) when economic targets differ from their
goals. It attempts to describe and summarize what the Fed has done in the
past. When the Fed changes its policy, the reaction function will change.

If Congress wanted to instruct or limit the Fed.'s behaviour (reaction) in
advance, it would find it impossible to put correct parameters into the
reaction function. e.g. by how much should the Fed  raise the FF rate when
pdot exceeds its target by x percent? Even the Fed itself could not put in
the appropriate number. It all depends... the system is open.

Congress could possibly direct the Fed to set up a target range, over which
the FF's rate would be allowed to move, and possibly set a long term
average target, so as to establish a range within which expected future
values of the short term rate was expected to move. This might provide
reduced uncertainty for participants in the bond and stock markets??

But the key fact about exogenous interest rates is that the Fed has a
considerable range of discretion over the rate it sets at any particular
time. Neither the rate nor the reaction can be set in advance.

Basil Moore


At 01:11 AM 2/16/00 -0500, you wrote:
>I would like to thank all who contributed to the discussion on the technical
>validity of the Taylor Rule.
>It appears that there is a general conscensus that the rule does reflect a
>reasonable range of fed funds rates within a given set of monetary policy
>objectives.
>The intriging political issue is whether the WSJ's highlighting the Taylor
>Rule at
>this particular time represents a move to try to curb the power of the Federal
>Reserve (labeled by libertarians as the unelected fourth branch) by
>substituting
>the discretionary and secrective power of the FR Board with a rule that the
>market
>can easily use.
>
>The Black-Scholes Formula made possible dynamic hedging which in turn
>brought about
>the revolution in financial engineering and changed the nature of risk from a
>liability to an asset.
>Dynamic hedging reduced risk by creating a perfect equilibrium in which
>fluctuations in the portfolio cancelled each other out. Black and Scholes
>found a
>theoretical way to neutralize risk. Two risky positions taken together can
>effectively eliminate risk itself. The application of mathematics to risk
>management would lead to the creation of a multi-trillion dollar derivatives
>industry.
>
>If the Fed officially adopts the Taylor Rule, it might conceivably
>revolutionize
>the fixed income market by removing a major uncertainty - the discretionary
>power
>of the Fed to set ST interest rates.
>
>Henry C.K. Liu
>
>Basil Moore wrote:
>
>> The Taylor Rule attempts to summarize and describe ex post the CB's Policy
>> Reaction Function.
>> Since the CB has discretionary authority to set the ST rate, any estimated
>> rule will not fit new CB administrations, or even the same administration
>> (regime) over different time periods.
>> This is the meaning of the statement that the CB sets interest rates as an
>> EXOGENOUS policy instrument. It has discretion as to the rate that it sets.
>> A good example is Volker's raising the ST rate to 20 % in 81. The CB never
>> likes to acknowledge  its exogeneity in setting rates, since high rates are
>> very unpopular. So it is Delphic and nontransparent in its statements, and
>> frequently finds a scapegoat, e.g the government' s deficit, or the crisis
>> in Asian markets, etc.
>> Basil Moore
>>
>> At 06:05 PM 2/8/00 -0800, you wrote:
>> >One tricky part of Taylor's rule is figuring out what the threshold
>> >maximum rate of growth is (or the threshold minimum level of unemployment)
>> >that should trigger interest rate changes (this is like trying to
>> >estimate the NAIRU, no?).
>> >
>> >And another tricky part is how much to raise rates (especially since we
>> >can't find a stable relationship between the short rates that central
>> >banks can influence (such as the federal funds rate) and the longer rates
>> >that actually have some influence over bank lending and aggregate demand
>> >for products (and so demand for labor, and perhaps wages, and perhaps
>> >unit labor costs, and perhaps price inflation).
>> >
>> >Rules are a conceit of
>> >technocrats, and can't be used except as rough rules of thumb to begin an
>> >analysis of what a policy response ought to be, in my humble opinion.  The
>> >world keeps changing....
>> >
>> >Chris
>> >
>> >On Tue, 8 Feb 2000, [iso-8859-1] ÁÎÓ¹â HenryC.K.Liu  [iso-8859-1] ¹ù¤l¥ú
>> >wrote:
>> >
>> >>
>> >>
>> >> "J. Barkley Rosser, Jr." wrote:
>> >>
>> >> > Henry,
>> >> >      The Taylor Rule is better than a Friedman
>> >> > fixed money growth rate rule, if one insists on
>> >> > having a rule.  I gather that some on the Fed, such
>> >> > as Gramlich, are definite fans.  But Greenspan
>> >> > would prefer to play the cards more discretionarily,
>> >> > at least officially.
>> >>
>> >> It is interesting that neo-liberals advocate rule based regimes for the
>WTO
>> >> while they oppose rule based interest rate regimes.
>> >> A case can be made that Greenspan may be merely protecting his  power by
>> >> hiding behind the myth of some mystical priestly role of intuitive
wisdom.
>> >> The fact is that the Taylor Rule seems to attract attention because
>> >> historical data tended to substantiate its claims.
>> >> One of the most venerable weaknesses of any central bank is the suspicion
>> >> that it plays politics with interest rates.  The Taylor Rule will disarm
>> >> this suspicion.
>> >> I am not competent to judge if the Taylor Rule works technically,
>beyond the
>> >> fact the historical data seem to prove its applicability.  Surely, if a
>> >> formula can be constructed to price risk (with Nobel respectibility), one
>> >> should be available to determine the right interest rate for a particular
>> >> set of economic policy goals.
>> >>
>> >> Henry
>> >>
>> >> >
>> >> >       John Taylor was the chief economic adviser to
>> >> > Bob Dole in the 1996 presidential campaign.
>> >> > Barkley Rosser
>> >> > -----Original Message-----
>> >> > From: ÁÎÓ¹â HenryC.K.Liu ¹ù¤l¥ú <hliu@xxxxxxxxxxxxxx>
>> >> > To: POST-KEYNESIAN THOUGHT <pkt@xxxxxxxxxxxxxxxx>
>> >> > Date: Tuesday, February 08, 2000 12:20 PM
>> >> > Subject: The Taylor Rule
>> >> >
>> >> > >The WSJ today (February 7, 2000 page B1) has a report on the Taylor
>> >> > >rule: Could One Little Rule Explain All of Economics?
>> >> > >The rule: if inflation is one percentage point above the Fed's gaol,
>> >> > >rates should rise by 1.5 percentage points. And if an economy's total
>> >> > >output id one percentage point below its full capacity, rates should
>> >> > >fall by half a percentage point.
>> >> > >
>> >> > >Now the Taylor rule was news back in 1992 and Taylor has made
headlines
>> >> > >in the past when he unsuccessfully lobbied for the Fed Vice Chairman
>> >> > >job.
>> >> > >
>> >> > >The WSJ hinted that Taylor is Bush's short list for Fed governorship.
>> >> > >
>> >> > >Any comments from PKT scholars on the Taylor rule?
>> >> > >
>> >> > >Henry C.K. Liu
>> >> > >
>> >> > >
>> >>
>> >>
>> >
>