Thursday, 2 June 2011

Journalists and economics :-(

One of the things that economist John Taylor is famous for is the Taylor Rule (the Taylor Rule says that the federal funds rate should equal 1.5 times the inflation rate plus .5 times the GDP gap plus 1), something so well known now that even journalists have heard of it. Unfortunately. Note the following:
Over at Market Beat:'s inside look at the markets, Mark Gongloff reports that Standard Chartered’s David Semmens says that “Based on a strict Taylor-rule calculation, the first effective fed-funds rate increase shouldn’t come until the first quarter of 2013.”
So the Taylor Rule tells us that interest rates should stay basically where they are, at least for now.
And over at Business Insider, Art Cashin of UBS reports that Jim Brown of Premium Investor says that “the Taylor rule says the Fed funds rate should be -1.65%” suggesting the need for a QE 2.5.
So the Taylor Rule also tells us that interest rates should fall.

No calculations are given in either of these articles. I wonder if the journalists involved ever thought that checking the calculations of the results they were reporting would be a good idea? As it turns out such a thought would have been at good idea as at his blog, Economcis One, John Taylor writes,
So I think the economy would be better off if the Fed started moving to a higher funds rate now rather than later, and I certainly see no rationale for another round of quantitative easing.
Thats right, John Taylor says that the Taylor Rule argues for an interest rate increase and he provides the calculations to back it up.
Over here at Economics One, I can report that the Taylor Rule says that the fed funds rate should now be 1 percent, and I can provide the calculations. Available data (through the 1st quarter) show that the inflation rate is about 1.6 percent (GDP deflator smoothed over four quarters) and the GDP gap is about 4.8 percent (average of San Francisco Fed survey). This implies an interest rate of 1.5 X1.6 + .5X(-4.8) + 1 = 2.4 - 2.4 +1 = 1.0 percent.


James said...

But when the Taylor rule was introduced it was just a historical description of the relationship between the Fed Funds rate and inflation and GDP. It didn't say anything about what the rate should do, just that that's what it has done.

In the (current) monetary policy analysis I've read, the Taylor rule is usually compared to optimal monetary policy rules to see whether they differ very much.

Perhaps I've missed something, but what has changed about the interpretation of the Taylor rule that makes people think we should use it to see where interest rates should be (as opposed to where they would be if the Fed followed the decision rules it has over history)?

Paul Walker said...

The interpretation given to the rule in the message is by John Taylor himself, so I guess he thinks it can be use to say where rates should be.

James said...

The main criticism of the Taylor rule as a prescriptive (rather than merely descriptive) policy seems to be that:

"the classic formulation [of the Taylor rule] assumes that
interest rates should be set on the basis of current measures of the target variables [the output gap and inflation] alone,
but an optimal rule will generally involve a commitment to history-dependent behavior; in
particular, more gradual adjustment of the level of interest rates than would be suggested
by the current values of either the target variables or their exogenous determinants has
important advantages."

With respect to Taylor's own suggestion toward the end of your post, then, he's likely to be overstating the case for raising rates since he's basing it on his own rule.

While better journalistic fact checking would be nice, an all-round better understanding that what "is" (i.e. past interest rate behaviour) is not necessarily what "ought to be" (i.e. how policy making can best be conducted) would be nicer.