John B. Taylor is one of the profession’s most recognized macroeconomists, and for good reason. He has made numerous contributions to theories on wage and price formation and monetary policy. Many concepts are so central that they carry his name. “Taylor contracts” (staggered nominal wage or price contracts that are a central ingredient in many macroeconomics models), “Taylor curves” (curves that simply illustrate the feasible monetary policy trade offs), and, of course, the “Taylor Rule”, which is a specification of a nominal interest rate rule for a central bank.
Originally mentioned in a 1993 paper, Taylor showed that the simple rule—that recommends that the nominal interest rate adjust to inflation and output deviations from trend—tracked actual policy setting by the Fed for the previous six years quite well. This had an enormous influence on subsequent monetary policy theory where a Taylor rule is often used as a simple way of illustrating monetary policy conduct. Also, tons of empirical papers have examined the empirical relevance of Taylor rules in the US and everywhere else.
Now the rule has entered into a new dimension: the legislative sphere. Republicans want to pass a bill where the Fed is required to specify the rule it follows. John Taylor (an open advisor for republicans) has, not surprisingly, supported the idea. Such “Taylor legislation” is, however, slightly milder than one would believe, as it should instruct the Fed to follow a rule of its own liking; not necessarily the Taylor rule per se.
Following this, Krugman and Taylor have had their usual blog shoot-out concerning the cons and pros of such legislation. Most disagreement is on whether the Taylor rule was followed or not before the Great Recession, or whether one is talking about the correct Taylor rule, or whether it was or was not (in part) responsible for the crisis. (Tony Yates points out some more academic and practically based views against legislation that are overlapping with mine in many respects.)
Such disagreement in itself shows the danger of committing to even a particular simple rule. Two leading economists can’t even make head or tails about whether the rule has actually been followed or not. And even though Taylor has emphasized that the Taylor Rule should be seem as a normative prescription (and not just a vehicle for describing policy behavior in practice), his original paper is full of qualifiers that states that one should only see such a rule as a benchmark, and that deviations from the rule would be a good thing under various circumstances. And that makes a LOT of sense, showing that for practical purposes a “rule” is a misnomer and never a good thing (unless it can be made contingent on all foreseeable and non-foreseeable events).
But wait a minute. Hasn’t a long literature following Kydland and Prescott (1977), pointed to the desirability of rules over discretion? Would it not be better to “tie the hands” of policymakers? The answer is yes, but one must also remember (and understand) that the “rules” Kydland and Prescott talked about, were those that solved time-inconsistency problems (credibility problems) of optimal policy. I.e., they are policy prescriptions that are optimal and do not succumb to temptations to deviate to reap short-sighted gains. I.e., they are a description of optimal commitment behavior. A Taylor rule does not belong to that family in most of the models in which it is used. So yes, it is a rule in a semantic sense, in the sense of describing a given simple behavioral pattern to follow, but it is not a rule in the Kydland and Prescott meaning. So forget about rules vs. discretion arguments.
If one wants to raise the bar for legislation in monetary policymaking, one should acknowledge that policymakers act discretionary, i.e., on a day-by- day basis trying to achieve its goals. (Janet L. Yellen’s comments on the FOMC press conference December 17, 2014, has discretion written all over it; see p. 12). Therefore one must provide them with clear goals. There is a vast literature on delegation of monetary policymaking that shows how intermediate goals can bring discretionary policymaking closer to the Kydland/Prescott-style commitment-style behavior. Price level targeting or nominal income growth targeting are some of the alternatives. These are alternatives that can work well, since reaching these goals imply that the policymaker takes the past into account. This is beneficial if one believes that credibility is important: When you respond to past events, you can influence future expectations better to your current advantage (because what you do today will affect future policy and thus expectations).
In view of the above, the Taylor rule raises a conundrum: In environments where expectations are unimportant and credibility problems are absent, rendering the rules vs. discretion distinction irrelevant, a Taylor-type rule can be optimal (cf. Svensson, 1997). On the other hand, if expectations are important, the Taylor rule is rarely optimal. It is not a behavioral pattern that solves credibility problems, just because it has the word “rule” attached.
Actually, one of its celebrated implications, the “Taylor principle” (another term that carries Taylor’s name), should not necessarily be observed in optimal and credible policymaking. The Taylor principle states that the coefficient on inflation in the Taylor rule should exceed one, such that inflationary pressures lead to a more than one-for-one increase in the nominal rate, thereby increasing the real interest rate. But if a central bank enjoys credibility and can manipulate expectations to its advantage, it can obtain stable inflation with rather small fluctuations in the nominal rate. Indeed one could then in practice observe a negative coefficient on inflation. I have shown elsewhere that one can estimate Taylor rules with such properties in model economies where the policymaker is performing as good as it gets. On the other hand ,Taylor rules satisfying the Taylor principle could be an indication of discretionary policymaking. To reiterate: “Commitment versus discretion” is not the same as “Taylor rule versus discretion”.
It is not a good idea to require that a central bank should publish a particular behavioral rule. If it should work, it would be way too complicated to specify, and if it should be simple (as the Taylor rule), policy is just being constrained in an arbitrary way. I don’t think there is a meaningful middle way. It would just lead to endless political debates on whether the “rule” has been violated or not, and if so why. And whether actual policy in the past, good times or bad times, can be characterized by a Taylor rule is rather irrelevant for this type of legislation. The US now, may not be as it was in 1987-92.
As in all branches of economics, good policy design is about shaping incentives appropriately. Requiring by law any decision making agent to directly act in a particular way is usually not a good idea. If it was, then why not solve unemployment problems by requiring all firms to adhere to a hiring rule that secures full employment?