Andy Harless: Whats Wrong with the Taylor Rule

Andy Harless: Whats Wrong with the Taylor Rule

via Brad DeLong's Grasping Reality with Both Hands by J. Bradford DeLong on 5/14/11

AH:

Employment, Interest, and Money: Fixing What’s Wrong with the Taylor Rule: I see four problems with the original Taylor rule: It’s not really a rule at all... [but] depends on an estimate of potential output... the discretion that goes into central banking is in the estimate of potential output.... It doesn’t self-correct for missed inflation rates.... It leaves the price level indeterminate in the long run.... It leaves the central bank without an effective tool to reverse deflation.... It reduces the credibility of central bank attempts to bring down high inflation rates, because the bank always promises to forgive itself when it fails.... It doesn’t allow for convexity in the short-run Philips curve. If the estimate of potential output is too low, for example, and the coefficient on output is sufficiently low, then, if the short-run Philips curve is convex, the central bank will allow output to persist below potential output for a long time before “realizing” that it has made an error.... It can prescribe a negative interest rate target, which is impossible to implement....

So how do we fix these problems? I suggest the following solutions:

Adopt a fixed method for estimating potential output.... Replace the target inflation term with a target price level.... Increase the coefficient on output... [to get] a more aggressive Taylor rule.... “Borrow” basis points from the future when there are no more basis points available today. In other words, if the prescribed interest rate is below zero, the central bank promises to undershoot the prescribed interest rate once it rises above zero again....

What have I proposed? I have proposed nominal GDP targeting....

If you wish, you can go further by making the rule forward-looking.... And you can enforce the credibility of the forecast by requiring the central bank to use the forecast implicit in a publicly traded nominal GDP futures contract, so that the market is putting its money where the central bank’s mouth is. You end up with the proposal that Scott Sumner has already made. People seem to think that Scott Sumner’s ideas about monetary policy are far out of the mainstream. But I’m not proposing anything radical here, just trying to fix some problems with the very orthodox Taylor rule.