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

[Basil Moore <bmoore@xxxxxxxxxxxxxxxxx>]

Henry
You write very well. I hope you are a fast typist. I unfortunately am not,
so I will be brief.  What you say below
 I tried to say (up to the late 80's) in Ch.'s 10 and 11 of my book
HORIZONTALISTS AND VERTICALISTS , CUP, 1988. I don't know (and cannot tell
from your note) whether you have looked at it?

My key point here is that the CB cannot use any PRESCRIPTIVE rule to set
the short term rate. The rate set depends on the state of the economy and
the CB's expectations of its future position relative to its policy
objectives. There is no question of "Rules versus Discretion" here. One
cannot prescribe rules for future behaviour when one cannot know the future
one is attempting to affect.

Basil Moore




At 01:37 AM 3/1/00 -0500, you wrote:
>
>
>Basil Moore wrote:
>
>> 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.
>>
>
>The Taylor 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.
>
>You are correct, Basil, that the rule has only been applied ex post facto, to
>sustantiate its validity.
>But I am not as certain as you are about Taylor's intention of restricting
>it to a
>descriptive tool.  He very much wanted to be Chairman of the Fed Board and had
>every intention of apply the rule had he the power to do so.
>
>The following is how the Fed describes its decision process:
>
>The Federal Reserve?s monetary policy actions have an immediate effect on the
>supply of or demand for reserves and the federal funds rate, initiating a
>chain of
>reactions that transmit the policy effects to the rest of the economy.
>The Federal Reserve can change reserves market conditions by using three main
>instruments: reserve requirements, the discount rate and open market
>operations.
>
>The reserve requirements (currently 10%) are set by the Federal Reserve
>under the
>Depository Institutions Deregulation and Monetary Control Act of 1980.
>At present, these reserve requirements apply only to checkable or
>transactions deposits, which include demand deposits and interest-bearing
>accounts
>that offer unlimited checking privileges.
>
>Directors of the Reserve Banks set the discount rate and initiate changes in
>it,
>subject to review and determination by the Board of Governors. The Reserve
>Banks
>administer discount window lending to depository institutions, making
>short-term
>loans.
>
>The Federal Open Market Committee (FOMC) directs the primary and, by far,
>the most
>flexible and actively used instrument of monetary policy?open market
>operations?to
>effect changes in reserves.
>The Chairman of the Board of Governors presides over FOMC meetings,
>currently eight
>per year, in which the Chairman, the six other governors, and the 12 Reserve
>Bank
>presidents assess the economic outlook and plan monetary policy actions.
>
>Under the Federal Reserve Act as amended by the Full Employment and Balanced
>Growth
>Act of 1978 (the Humphrey-Hawkins Act), the Federal Reserve and the FOMC are
>charged with the job of seeking ?to promote effectively the goals of maximum
>employment, stable prices, and moderate long-term interest rates.?
>The Humphrey-Hawkins Act requires that, in the pursuit of these goals, the
>Federal
>Reserve and the FOMC establish annual objectives for growth in money and
>credit,
>taking account of past and prospective economic develop-ments.
>This provision of the Act assumes that the economy and the growth of money and
>credit have a reasonably stable relationship that can be exploited toward
>achieving
>policy goals. The law recognizes, however, that changing economic conditions
>may
>necessitate revisions to, or deviations from, monetary growth plans.
>
>Since about 1980, far-reaching changes in the financial system have caused
>considerable instability in the relationship of money and credit to the
>economy. In
>particular, monetary velocities?ratios of nominal GDP to various monetary
>aggregates? have shown frequent
>and marked departures from their historical patterns, making the monetary
>aggregates unreliable as indicators of economic activity
>and as guides for stabilizing prices.
>Velocities of M1 (currency, checkable deposits and travelers checks of
non-bank
>issuers) and M2 (M1 plus saving and small time deposits and retail-type money
>market mutual fund balances) have fluctuated widely in recent years, and their
>average values over the last five to ten years have been much different from
>their
>long-run averages.
>
>For example, until the late 1980s, M2 velocity had been relatively stable over
>longer periods, while its short-run movements were positively correlated to
>inter-est rate changes. In the early 1990s, how-ever, M2 velocity departed
>from its
>historical pattern and drifted upward even as interest rates were declining.
>
>Some observers believe that ongoing, rapid financial changes will continue
>to cause
>instability in the financial linkages of the economy, undermining the
>usefulness of
>money and credit aggregates as guides for policy. Others expect the financial
>innovation process to settle down, leading to a restoration, at least to some
>extend, of the usefulness of money and credit as policy guides.
>
>Whatever the future outcome of these controversies, the Federal Reserve has
>been
>obliged, for some time now, to reduce its reliance on numerical targets for
>money
>and credit in formulating monetary policy. In recent years, the FOMC has
used a
>wide range of financial and nonfinancial indicators in judging economic
>trends and
>the appropriateness of monetary and financial conditions, and in making
>monetary
>policy plans. In effect, under this eclectic approach, the FOMC?s strategy for
>changing bank reserve levels aims at inducing broad financial conditions
>that it
>believes to be consistent with final policy goals.
>
>In making monetary policy plans, the Federal Reserve and the FOMC are
>involved in a
>complex, dynamic process in which monetary policy is only one of many forces
>affecting employment, output and prices.
>The government?s budgetary policies influence the economy through changes in
>tax
>and spending programs. Shifts in business and consumer confidence and a
>variety of
>other market forces also affect saving and spending plans of businesses and
>households. Changes in expectations about economic prospects and policies,
>through
>their effects on interest rates and financial conditions, can have significant
>influence on the outcomes for jobs, output and prices. Natural disasters and
>commodity price shocks can cause significant disruptions in output supply
>and the
>economy. Shifts in international trade rules and regulations and in economic
>policies abroad can lower or raise the contribution of the exter-nal sector
>to the
>U.S. economy.
>
>The FOMC also must estimate when, and to what extent, its own policy actions
>will
>affect money, credit, interest rates, business developments and prices.
>Since the state of knowledge about the way the economy works is quite
>imperfect,
>policymakers? understanding of the effects of various influences,
including the
>effect of monetary policy, is far from certain. Moreover, the working of the
>economy changes over time, leading to changes in its response to policy and
>nonpolicy factors.
>On top of all these difficulties, policymakers do not have up-to-the-minute,
>reliable information about the economy, because of lags in the collection and
>publication of data. Even preliminary published data are frequently subject to
>significant errors that become evident in subsequent revisions.
>
>In all of this, there is no escape from forecasting and from using judgment
>to deal
>with the uncertainties of data and the policy process.
>Indeed, monetary policy formulation is not a simple technical matter; it is
>clearly
>an art in that it greatly depends on experience, expertise and judgment.
>
>Determining the appropriate reserve market conditions?that is, the desired
>degree
>of monetary policy restraint?also is very complicated. In choosing an
operating
>strategy, the FOMC attempts to achieve a desired degree of monetary policy
>restraint, ease or tightness, by focusing on the reserve supply relative to
>demand,
>and the associated level of the federal funds rate. The Domestic Open Market
>Desk
>at the Federal Reserve Bank of New York can come reasonably close to meeting
>short-term objectives for nonborrowed reserves? supply of reserves excluding
>discount window borrowing.
>The contemplated reserve levels are based, of course, on the FOMC?s desire to
>induce short-run monetary and financial conditions that will help to achieve
>policy
>goals for the economy.
>
>In principle, the FOMC can aim for direct control of the quantity of
>reserves by not accommodating observed fluctuations in the demand for
reserves.
>However, this will result in free movements in the federal funds rate.
>Alternatively, the FOMC can control the fed-eral funds rate by adjusting the
>supply
>of reserves to meet all changes in the demand for reserves; this will
allow the
>quantity of reserves to vary freely. Over the years, the actual approach has
>been
>adapted to changing circumstances. Sometimes the emphasis has been on
>controlling
>the quantity of reserves; other times, the federal funds rate.
>
>While the FOMC generally has not aimed at precise control of the quantity of
>reserves, the operating strategy from October 1979 to late 1982 was closely
>consistent with this approach. Concerned over rapidly accelerating inflation
>in the
>late 1970s, the Committee sought changes in its operating procedures in
>order to
>control money stock growth more effectively. In October 1979, the Committee
>began
>targeting nonborrowed reserves, allowing the federal funds rate to fluctuate
>freely
>within a wide and flexible range. Under this approach, the targeted path for
>nonborrowed reserves was based on the FOMC?s growth objectives for
M1?currency,
>checkable deposits and travelers checks of nonbank issuers.
>M1 growth in excess of the Committee?s objectives would cause the depository
>institutions? demand for reserves to out-strip the nonborrowed reserves
target,
>putting upward pressures on the funds rate and other short-term rates. The
>rise in
>interest rates, in turn, would reduce the growth in checkable deposits and
>other
>low-yielding instruments, bringing money stock growth back toward the
>Committee?s
>objectives.
>
>The reserve targeting procedure from 1979 to 1982 gradually came to provide
>assurance to financial markets and the public at large that the Federal
Reserve
>would not underwrite a continuation of high and accelerating inflation.
>Reinforcing
>this procedure?s built-in effects on money market conditions were judgmental
>changes in nonborrowed reserve objectives and in the discount rate. Monetary
>policy
>contributed importantly to lowering the inflation rate sharply, albeit not
>without
>a significant increase in interest rate volatility and a period of marked
>decline
>in output.
>
>The historical relationship between M1 and the economy broke down in the early
>1980s, leading the FOMC to de-emphasize its control of M1 during 1982.
>In late 1982, the Committee abandoned the formal reserve targeting procedure
>and
>moved toward accommodating short-run fluctuations in the demand for
>reserves, while
>limiting their effects on the federal funds rate.
>
>Subsequently, ongoing deregulation and financial innovation precluded a
>return to
>the use of numerical objec-tives for M1 and the nonborrowed reserve targeting
>procedure.
>As a consequence, since 1982, the Federal Reserve?s operating proce-dures have
>focused on achieving a particu-lar degree of tightness or ease in reserve
>market
>condi-tions rather than on the quantity of reserves.
>
>Specifically, the FOMC expresses its operating directives in terms of
>a desired degree of reserve pressure?that is, the costs and other conditions
>for
>the availability of reserves to the banking system ? which is associated
>with an
>average level of the federal funds rate. The approach for evaluating the
>degree of
>reserve pressure, however, has changed over time.
>
>Discount window borrowing targets were used as the main factor for assessing
>reserve availability conditions during 1983-87, but they have not played a
>significant role through much of the subsequent period.
>
>Under the current approach, the FOMC uses the federal funds rate as the
>principal
>guide for evaluating reserve availability conditions and indicates a desired
>level
>of the federal funds rate. This judgmental approach involves estimating the
>demand
>for and supply of reserves, and accommodating all significant changes in the
>demand
>for reserves through adjustments in the supply of nonborrowed reserves. It
>allows
>for only modest day-to-day variations in the funds rate around the level
>intended
>by the Committee.
>
>The money market?which includes the federal funds market ? provides the
natural
>point of contact between the Federal Reserve and the financial system.
>The money market is a term used for wholesale markets in short-term credit
>or IOUs,
>comprising debt instruments matur-ing
>within one year. The market is international in scope and helps in
>economizing on the use of cash or money.
>
>Borrowers who are the issuers of short-term IOUs ? generally,
>the U.S. Treasury, banks, business corporations and finance companies ? can
>bridge
>differences in the timing of receipts and payments or can defer long-term
>borrowing
>to a more propitious time. The market allows the lenders ? businesses,
>households
>or governmental units ? to offset uneven flows of funds by allowing them to
>invest
>in short-term interest-earning assets that can be readily converted into
>cash with
>little risk of loss. They can also time their purchases of bonds and stocks to
>their particular views of long-term interest rates and stock prices.
>
>The main instruments of the money market are federal funds, Treasury bills,
>repurchase agreements (RPs), Eurodollar deposits, certificates of deposits
>(CDs),
>bankers acceptances, commercial paper, municipal notes and federal agency
>short-term securities. The stock-in-trade of the market includes a large
>portion of
>the U.S. Treasury debt and federal agency securities. The daily dollar
>volume in
>this market is very large, several times that of the most active trading
>days on
>the New York Stock Exchange.
>
>Banks are at the center of the money market, with their customer deposits
>and their
>own reserve bal-ances at the Federal Reserve serving as the core element
in the
>flow of funds. Large banks borrow and lend huge sums of money, on a daily
>basis,
>through the fed-eral funds market. They are also particularly active in the
>markets
>for RPs, Eurodollars and bankers acceptances.
>Many banks act as dealers in money market securities, while many others offer
>short-term investment services.
>
>Short- and Long-term Interest Rates
>
>Interest rates have frequently been proposed as a guide to policy.
>Surely, some argue, changes in the provision of reserves by the
>Federal Reserve can influence interest rates, and changes in interest
>rates affect various spending decisions. Moreover, information
>on interest rates is available on a real-time basis.
>
>Arguing against giving interest rates a key role in guiding monetary
>policy is the uncertainty about what level or path of interest
>rates is consistent with the more basic goals. The appropriate level
>or path will vary with the stance of fiscal policy, changes in pat-terns
>of business and household spending, the productivity of capital, and
>economic developments abroad. It is difficult not only to gauge the
strength of
>these various forces at any time but also to translate them into an
appropriate
>level of interest rates. Moreover, real interest rates?that is, interest
>rates net
>of expected inflation?drive spending decisions. Expected inflation is not
>readily
>measured; thus, assessing what the level of real interest rates happens to
>be is
>difficult. However, failing to account for inflation ex-pectations can
>result in
>misleading signals coming from nominal interest rates.
>
>For example, if the public expected more inflation, nominal interest rates
>would
>tend to rise, as investors sought pro-tection for the greater loss of
>purchasing
>power, and might lead to the belief that monetary policy had become
tighter and
>more disinflationary when, in fact,
>just the reverse had occurred.
>
>Alternatively, the yield curve?the difference between the interest rate on
>longer-term securities and the interest rate on short-term instruments?has
been
>proposed.
>
>Whereas short-term interest rates are strongly influenced by current reserve
>provisions of the central bank, longer-term rates are influenced by
>expectations of
>future short-term rates and thus by the longer-term effects of monetary
>policy on
>inflation and output.
>
>For example, a steep positive yield curve (that is, long-term rates far
>above short-term rates) may be a signal that participants in the bond market
>believe that monetary policy has become too expansive and thus, without a
>monetary
>policy correction, more inflationary. Such a curve would be telling the
central
>bank to provide fewer reserves.
>
>Conversely, an inverted yield curve (short-term rates above long-term rates)
>may be
>an indication that policy is restrictive, perhaps overly so.
>
>However, various other influences, such as uncertainty about the course of
>interest
>rates, affect long-term interest rates. Thus, a steepening of the yield
>curve may
>indicate not that the thrust of monetary policy is too expansive, but that
>market
>participants have become more uncertain about the outlook for interest rates.
>In other words, liquidity premiums embodied in long-term interest
>rates may have risen. More generally, interest rates can vary for
>a variety of reasons, especially over short periods, and the Federal
>Reserve must exercise considerable caution in interpreting and reacting to
>their
>fluctuations.
>
>Exchange rate movements are an important channel through which monetary policy
>affects the economy, and they tend to respond
>promptly to a change in the provision of reserves and in interest
>rates. Information on exchange rates, like that on interest rates, is
>available almost continuously throughout each day.
>
>Interpreting the meaning of movements in foreign exchange rates, however, is
>not
>always straightforward.
>
>A decline in the foreign exchange value of the dollar, for example, could
>indicate
>that mon-etary policy had become more accommodative, with possible risks of
>inflation. But foreign exchange rates respond to other influences, such as
>market
>assessments of the strength of aggregate de-mand or developments abroad.
>
>For example, a weaker dollar on foreign exchange markets could instead suggest
>lessened demand for U.S. goods and decreased inflationary pressures.
>Or a weaker dollar could result from higher interest rates abroad?making
>assets in
>those countries more attractive?that could come from strengthening economies
>or the
>tightening of monetary policy abroad.
>
>Determining which level of the exchange rate is most consistent with the
>ultimate
>goals of policy can be difficult. Selecting the wrong level could lead to a
>sustained period of deflation and high levels of economic slack or to a
greatly
>overheated economy. Also, reacting in an aggressive way to exchange market
>pressures could result in the transmission to the United States of certain
>distur-bances from abroad, as the exchange rate could not adjust to cushion
>them.
>
>Consequently, the Federal Reserve does not have specific targets for
>exchange rates but considers movements in those rates in the context of other
>available information about financial markets and economies at home and
abroad.
>End
>
>Now, it is amazing that the Taylor Rule, within a very narrow range,
>outguessed
>all the above complexity in determining operative targets for interest rates.
>
>Henry C.K. Liu
>