Stanford University economist John Taylor, a candidate to become the next chairman of the Federal Reserve, laid out his case for monetary policy rules Friday, Oct. 13, 2017, at an economic conference on the topic hosted by the Federal Reserve Bank of Boston. Former Fed Vice Chairman Donald Kohn discussed Mr. Taylor’s presentation. They also took questions and comments from the audience, which included Boston Fed President Eric Rosengren, Dallas Fed President Robert Kaplan and former Fed governor Frederic Mishkin. Here is a transcript of the discussion, lightly edited for length and clarity.
JOHN B. TAYLOR: OK, thank you very much. Thanks for inviting me. I’m looking forward to this conference. I really enjoyed listening to Eric Rosengren to get us started, a very comprehensive overview. I appreciate that. It’s good to see lots of old friends here, and I’m really looking forward to a good discussion today.
I thought that the preparation of the Boston Fed staff was really good. In fact, in my discussion I want to focus on the questions that they addressed. I thought it was a very useful format.
One thing I might just say at the beginning, the “Are Rules Made to be Broken? Discretion and Monetary Policy,” of course, is the overall title. And in the advertisement, the N in “broken” is falling over sideways. I didn’t do that in my picture, but it reminded me, I was telling President Rosengren beforehand, of a little book I like to read to my kids – actually, now grandkids – called “Chicka Chicka Boom Boom.” “Chicka Chicka Boom Boom” is about letters going up a tree. And it gets so high, overweight, they all fall down and they hurt themselves. And so the N is stooped in and the O is a twisted alley-oop, and the – all the letters – K is crying K. It’s beautiful, but maybe when we actually get the official version up I’ll put the letters from this – from this book. But it reminded me of that.
So let me just go through the questions, because I – (inaudible) – the questions which the Boston Fed staff suggested we address – I address in this session.
- Taylor Laments Central Bank’s Precrisis Monetary Policy
One is how policy rules have changed over time. I think it’s very important.
Second, to what extent have ways that we have thought about tying central bankers’ hands, and how has that evolved.
Third, very important, is how do we demarcate rules versus discretion. It comes up all the time. It’s somewhat easier to do that with a little formula than I think to do that in practice.
Fourth is how has – how has this research on policy rules affected the practice of central banking over time.
And fifth, how this congressional legislation that Eric referred to fits into the whole discussion.
So what’s quite comprehensive, and I’ll try to stick to that – those five questions as I go.
So starting with how thing have changed over time, I think it’s very important to recognize that thinking and research on policy rules really goes back to the beginning of economics. Economists have always been thinking about this. I have some quotes from Adam Smith, Henry Thornton. I have the dates wrong for Thornton, Ricardo basically mixed up – I apologize – for my slides. It’s correct in the paper. Thornton wrote in 1804, looking for an explicit mechanism for monetary policy. Ricardo, his famous book talked about that you had to have a rule of sorts for central banks. And of course, (Swedish economist Knut) Wicksell, with his formula for interest rates. Irving Fisher – (inaudible) – theory. (Henry) Simons and (Milton) Friedman, writing about policy rules.
And throughout this work, I think if you look at it, you see that the goal of these economists – and, of course, some of them very involved in policy – was to find a system that prevented monetary shocks, prevented the kind of strong shocks that affected our system adversely, but also that cushions the economy from other shocks. Because there are other shocks that hit the economy. We know that. They’re very important. So you want to have something that’s resilient to that. And because of those – both of those things, reduce the changes of high inflation, financial crises, and recessions.
And the idea that came out of this work, as I look at it and reviewed it in a handbook paper with (San Francisco Fed President) John Williams several years ago, was that there was really not so much a choice between a rule and discretion. It was frequently a rule versus a chaotic monetary policy. So just to start it’s kind of rules versus chaos, because there really was a concern of a very chaotic monetary policy both causing shocks and not responding to shocks very well. So that motivation, to me, has always been there to some extent. Rules versus chaos may be a little extreme to put it, but basically that was the concept.
This idea was taken forward in this century. And I like to think about going back to how models have been used to help us formulate rules. As economists, we use models, economic models.
So first model in macro was (Dutch economist Jan) Tinbergen’s famous model almost 80 years ago, and it was – it was actually designed to examine a monetary policy question. And that was: Should the guilder be devalued? Would that stimulate the economy? And his little model said it would stimulate the economy. And soon after he wrote and presented his paper, the Dutch authorities devalued the guilder by 20 percent. And so that had an impact on policy, an impact on monetary policy.
This kind of thinking about how to use policy and deliver on policy decisions I think of now as being done in what I’ll call “path-space.” Tinbergen is famous for distinguishing between instruments and the targets. His calculations in the ’30s generated an enormous amount of important research.
Cowles Commission, Cowles Foundation, Lawrence Klein developed models really with the purpose of evaluating policy, the distinction between structural and reduced forms. That whole thing was like that. And this research fed into monetary policy.
And one example of that was the MPS – the MIT-PENN-SSRC – model that came to the Fed and many other central banks, too. You can see this going on. But for the most part, this was what I call “path-space.” You’ve got this structure of the economy summarized in the model, and you simulate different paths for the money supply – mostly that, but also for the interest rate – and you saw what would happen. And I think to some extent that’s how – that’s a quick, but a reasonable description of how it worked.
This began to change fundamentally in the ’70s, I think. Part of it has antecedents. It goes back to people I just mentioned, like Milton Friedman, the advantages of rules. But there was a recognition that you didn’t have to have a fixed money-growth rule to see the advantages of rules.
And so a whole new way of thinking came into play. Models with rational expectations were built. Models with sticky wages and prices were built. And pretty soon you were able to answer – ask and answer questions about what would be a good rule for policy, what would be a good system – systematic way to design policy.
I mentioned the Brookings (Institution) Model Comparison project here because I think it was very important. It showed how you could use models to see which rule worked better and which didn’t. It was really just calculations what works better and what doesn’t.
And pretty soon after, the Fed’s model changed. FRB/US came – F-R-B/U-S – replaced the MPS model. And this occurred in many other central banks and around the world. Around the same time, different kinds of lags.
Volker Wieland has, I think very constructively and valuably, summarized a lot of this with his macro model database so you can see how this changed over time. So it’s certainly not just the Federal Reserve. It’s a general phenomenon.
Now, as these models came into play, they were very complicated. They included everything, all the things and more that Eric referred to. Very, very complicated models. And as a result, the calculations or the rules that came out of these were very complicated. The rules were very complicated. And that’s – I remember that very well. And that was a problem because they weren’t very useful. So complicated, how could you have policy makers use these? You had lags and 15 variables and things.
So a change occurred, and the rules became simple. And I was part of that, but many other people were too. And this gave a lot of attraction to the idea, really going back to the beginning of economic thinking on this, that you could have something relatively simple that would not create shocks and could react to shocks well. They were very easy to understand, and for some reason they got very popular, I think. So things like the so-called Taylor rule – and, obviously, I didn’t name it that, but it came into play. And I think one reason is that we – useful in financial markets. John Lipsky was working at Salomon Brothers at the time. He talks about that.
They turned out to be quite robust, surprisingly, because if you took not just the MPS, not just the FRB/US model but other models, they worked pretty well. I’ll give you some references to these work. They were useful in research. They began to help explain things. For example, why does the exchange rate tend to appreciate when inflation rises? If you think – that’s backwards; if inflation increased, maybe the currency should depreciate. But it was the other way, I think, when these policy rules were in play.
There were many variations. Again, this is the theme, how policy rules changed over time. There were many variations – inertial rules; when to include the lagged federal-funds rate; when to include other variables – the exchange rate, asset prices; when to include – put forecasts in rather than the actual variable. So many variations and many debates about whether this made sense or not.
Many of these I resisted myself. Forecast, yes, that sounds nice, but how good of a forecast? And to what extent do you already – have you already built in forecasts when you design a policy rule?
So those are some of the variations, and some of them are illustrated in the slides that we just saw a few minutes ago. A lot of international impact, as well, or international discussion.
Second thing about this thing, very important, is it seemed to work in practice, and I think that surprised lots of people. The best example of this was the work by (Richard) Clarida, (Jordi) Gali and (Mark) Gertler, which showed as the Fed became more rule-like in the sense I’m using, policy got better. And that’s the so-called Great Moderation. And you saw inflation become – come down, the business cycle less volatile, unemployment come down as well. And that really occurred pretty much at the time that you didn’t document a change to a more rule-like – not perfectly, a more rule-like policy that came under (Fed) Chairman (Paul) Volcker.
The very important phenomenon that then came, which is still controversial, is what happened, and when did the Great Moderation end, and why. And I’ve been writing for quite a while, and this is a very – should be a very important part of our discussion, that it was the deviation from those policies in 2003 and ’4 and ’5 especially that seemed to be the problem. So, when we think about the pros and cons of simple rules and rules, we need to remember that part.
I just looked up – (Wall Street Journal Global Economics Editor) Jon Hilsenrath did a survey of economists’ views of this. It was several years ago. He found that roughly 75 percent of economists felt that there was a problem in terms of policy that led to the crisis. Now, surveys are what they are, but it was a quite large fraction. So let’s not forget that. And (former Fed Vice Chairman) Don Kohn has kind of written about it as well.
And, of course, there are other explanations: Something went wrong in the financial system. People became too complacent. (Former Bank of England Gov.) Mervyn King and (BOE Gov.) Mark Carney and (former Fed chairman) Ben Bernanke have written about that.
But then there’s also work that tries to cover longer periods. David Papell, who’s here, and his colleagues (Alex) Nikolsko-Rzhevskyy and (Ruxandra) Prodan, have documented as best they can that a more rule-like policy works better in terms of price stability and output stability, these criteria that we use. And there’s international evidence. Yevgeniy Teryoshin, who’s a student at Stanford, is working on this. OK. So that’s this.
Now, just to continue this idea of rules changing over time briefly – because they’re still changing, and partly because of the crisis, you know, what went – what went on in the crisis. So there’s a renewed interest in nominal (gross domestic product) targeting, a lot of discussion of that.
The effect of lower bound or the zero lower bound has generated a huge amount of work. I think in some sense money-growth rules are coming back. There’s people who want to look at those because they don’t have a zero bound issue.
There’s, I think, a very important work by (David) Reifschneider and Williams. It’s meta rule – meta rule where, when the – when the funds rate is hitting close to – zero or close to zero, you have extra forward guidance about it staying low in the future. That paper was written before. It was written in 1999, by the way. It’s been out there a long time. It’s very important.
There’s price-level targeting as an alternative. That’s, to some extent, to the problems of the low inflation, higher inflation target.
There’s the what I call R-star wars. And this is, in a sense, a debate we’re having. Did R-star fall, as we saw in the charts before? And Thomas Laubach and John Williams have written a lot about that, and this is – the most recent work is with (Kathryn) Holston. They find it does, and it’s very close to the chart that you showed us a few minutes ago. And so that has to be taken into account, and the rules are changing for that reason.
And then, finally, I think it’s important to look at the future a little bit here. To me, nowcasting has changed a lot of this. It used to be that we – you know, it was hard to put the current quarter into these rules. Now it’s not that hard. Nowcasting is much better.
And, of course, digital central bank currency. Mike Bordo and Andy Levin have done a paper on how that’s going to affect central bank decision-making, and I think that’s important for the future.
OK. So that’s the summary of what has happened as background.
Now the second thing, which I’ll try to go through a little more quick – second charge – was the reasons for tying central bankers’ hands evolved. So I find this question a little difficult, because I don’t think of policy rules as reasons to tie central bankers’ hands. I’ve never thought of these as tying central bankers’ hands, never. To me they are ways to make monetary policy better. There are ways for central bankers to use them to make policy better.
And I made a list of the reasons for policy rules 20 years ago. You know, the time-inconsistency problem. It’s easier to explain policy, I think, if you have some principles. There’s less short-run political pressure, greater independence. It reduces uncertainty if you’re clearer what you’re doing. This is – teaching the art and science of central banking, I can’t emphasize that as much as – you know, I go around the world and you talk to central bankers, they love something – especially if they haven’t been a central banker until the day they’re on their job. (Laughter.) I mean, they like to have this. And accountability and benchmarking.
And when I look at these reasons, I think these are reasons why you should have a strategy of policy. And my good friend George Shultz and others – you know, he’s had many Cabinet positions, including secretary of state – and emphasizes, as I do, a strategy – not so much a little formula but a strategy. And if you don’t have a strategy, you don’t get anywhere. So in many respects, these rules are ways to think about strategies, and they don’t have to be as precise as that.
While we’re talking about the idea of limits, sort of a side but important point is that for an independent agency of government there has to be limits. It can’t do everything, and part of creating it is you don’t do everything. And so that seems, to me, go without saying. And granted independence, one needs a well-defined and somewhat limited purpose. I think we all agree to that. The question is, how do we apply it in practice? So it’s a related point.
Now, there have been – has been an evolution of reasons not to use policy rules, and they do have this idea of you don’t want to tie central banks’ hands. So I’ll give you one example, and that’s from (former Treasury Secretary) Larry Summers. He and I had a debate a few years ago, and he – I quote him: “I’d rather have a doctor that most of the time didn’t tell me to take some stuff, and every once in a while said I need to ingest some stuff.” That would be a doctor whose advice, believe me, would be less predictable, but he would like.
So the idea is you have a very smart – this is one person, OK, and not a committee – who makes the decision. And it’s forget about the rules, forget about strategy, forget about everything, and it’s right. It seems to me that misses an enormous amount of progress that has occurred in medicine, and that is the idea of checklists for surgeons, for doctors, for anything. And there’s – people have been writing about this, and it’s a way to improve medicine. And if doctors start to wing it and go off their checklist, it usually causes problems. So put that in mind when you think about statements like this. I write: “Checklist-free medicine is dangerous, like rules-free monetary policy.”
Another thing, which we’ll come back to later in this conference, is the idea of constrained discretion. So this is – this is – Bernanke has written about this a lot, and the idea here is all you need is a goal – 2 percent inflation, something on unemployment – and then you do whatever you need to do. Don’t need to talk about the strategies for instruments at all. And it is an appealing term, but to me it’s not really a description of a strategy if you don’t talk about what you’re doing with the instruments, OK? And when I say the evidence is that it has not worked very well, I’m talking about the poor performance over the last dozen years and the Great Recession and things like that, because I think there is a sense in which that approach didn’t work. We’re going to debate this, I understand. But it is quite different. It’s different than an instrument rule, instrument strategy approach.
And then the last thing I’ll mention in this section is the idea of forecast targeting, which Lars (Svensson) will discuss a lot. It’s quite different from the constrained discretion, because there’s a specific way to think about the settings of the instruments of policy, the interest rate, so that they deliver certain outcomes with respect to it. And this is my little picture of inflation and output. And so in this case you’d set your instruments so that the forecast of those are in a certain range.
And they do have advantages over other instrument rules because they include more information. They’re inherently more complex. They include everything in the model. And therefore, they’re somewhat model – they are model-dependent. And so we have to worry about that. And I think also, for that reason, you have to find a way how – how do you use it for accountability or communication.
I think this is progress. I would not say that this is not a way to go, by any means. But I think this is progress, but you do need to worry about these – what’s the model on how you do the diagnostic checks. I have argued in a paper gave at the – (inaudible) – by the way, that a method like this might very well fit into the legislation that’s passed the Congress.
OK, third thing: demarcation of discretion. I think this is a very important issue. McCallum, this is from his handbook paper a while ago. When it comes to practical applications of the behavior of actual central banks, the distinction is not easily drawn. And when I wrote the paper, whenever it was, ’93, the whole purpose was to go away from simple algebraic formulations and, as I say, to study the role of policy rules in a world where simple algebraic formulations of such rules cannot and should not be used mechanically by policy makers. So, anyway, that’s the whole – that’s the whole purpose. How can you make this workable in a real world where discretion is inherently needed?
It was that kind of decision, that kind of definition that led me and others, to some extent, to say that the ’85-2003 period was more rule-like compared to immediately before and immediately before. And of course, the policy performance was better. Now, to be more formal about this you have to be more specific. And that’s what David and his colleagues – (inaudible) – have done. They’ve defined discretion as deviations from particular rules. And I don’t see any way around that in terms of doing the research on this. Got to do something like that. I did it more informal. I think the more informal way is correct. But it’s an issue to address.
So when you think about this in practice, there’s lots of things that make it more complicated. And we’re going to come back to some of this in this conference as well. So, for example, if you have a policy rule that you’re analyzing with a model, it depends on whether you have a lag-dependent variable. And you know from doing any kind of econometrics the leg-dependent variables always show up in time series. They’re just – they sometimes mimic zero correlation. So they’re always going to be there. And is that the way to think about policy?
And deviations from that are going to be much different than deviations from a simple kind of Taylor rule. It absorbs a lot of stuff that you might not think is the right policy. So it’s very hard. There’s some optimal reasons to have that. And I’d say we need to think about when we do the research. I don’t think there’s anything wrong with the approach that I’ve suggested, but it needs more work.
One thing I just would add here, in some cases there are efforts – and you’ve all gone through them – to make deviations from simple rules more systematic, to try to find a way to do that. So one example I have in the – and I talked about this a lot at the time, 2007, 2008 – there was this big movement in Libor-OIS spread. We didn’t know what was going on. John Williams and I wrote about it. We thought it was a sign there was a problem with the banks. A lot of people ignored us. But there was a problem. So you want your policy rule to adjust for that. In this case, it would be about a 50-basis-points reduction because of the spread between Libor and OIS. Libor, unfortunately, is not as reliable in people’s minds as they thought it was then. But the point is still the same.
OK. Last two things on the list. The influence of this on central banking – I don’t think I need to say too much about this. I was surprised, quite frankly, how much these ideas have been discussed in policy circles. Of course, there’s been this correlation that I mentioned between rules and performance decisions. But evidence of direct effect is harder to come by. A very good paper by (George) Kahn of the Kansas City Fed, who went through all the transcripts and records and found, in the early ’90s, huge discussions of policy rules at the Fed. And they looked at central banks as well. I think it’s – it would be of some interest to see how this changed – or to what extent it changed in 2003, ’4 and ’5. And you really can’t rely entirely on the transcripts, because there’s lots of discussions that occur in other places. That’s just the way it is.
So I think it’s very important to try to understand that better. But there is a – really, for me, a striking degree to which these things have been discussed inside central banks. I know this from talking to central bankers. But the deliberation is quite interesting. So one thing that is also very interesting to me is how this seems to have changed a lot recently. And I’ll just – I mention this in the paper. We all know this so well. But and partly it’s related to the decision to normalize the balance sheet. And quite a bit of specificity about being predictable and gradual about this is the addendum that was added this past June. It’s very specific about, you know, the balance sheet will be reduced in size, the numbers are given. It didn’t ask for more than that, it seems to me.
It’s just different than the discussion of the taper tantrum, which was quite a shock to people. So that’s a – that’s a tremendous improvement. This year (Fed Chairwoman Janet) Yellen has given speeches, and (Fed Vice Chairman) Stanley Fischer has given speeches which, again, I think reflect some of these changes. So I quote from Chair Yellen, Janet, earlier this year: When the economy is weak and unemployment is on the rise, we encourage spending and investing by commissioning short-term interest rates lower as a strategy, as a rule. Similarly, when the economy is threatening to push inflation too high down the road, we increase interest rate, as a strategy, as a rule. There’s, of course, a 2 percent inflation target. There’s a 3 ¾ estimate of the natural rate. And now a discussion of the 3 percent equilibrium federal-funds rate, relatively speaking.
So that’s a change. Even more than that, in another talk earlier this year, Janet Yellen compared this with other rules. She looked at three. One of them was the Taylor rule. And I just summarized it at the bottom. So the paragraph I wrote sort of has the interest rate reacting to inflation and output, coefficients are not specified. The equilibrium rate is one in that picture. So the Taylor rule, the specific number, so it’s not hard to do this comparison. And you might want to compare with something else, but it’s not hard. And I think it illustrates how it can be fruitful.
And then this summer the monetary policy report of the Fed for the first time, as far as I know, had a whole section comparing decisions with policy rules. And specific statements, these are key principles of good monetary policy, that’s a quote. And one of the principles – this is sometimes called the Taylor principle. I’m not sure who made that name up. The policy rate should be adjusted by more than one for one in response to persistent increases or decreases in inflation. That’s in the report that’s written. So that’s a change. And there’s other things in this, but I think what’s good here is there’s some other influence that is coming. And I think that’s important.
I’ll just mention this is not for the United States. These are some quotes from people who have many different viewpoints – Paul Volcker, (former head of India’s central bank Raghuram) Rajan, (ECB President) Mario Draghi – all indicating that we need a more rules-based international system. And I’m written a lot about that. And I think that’s something to think about when you’re discussing whether a more strategic, more rules-based approach is good for one country. Because it ultimately will lead to a more rules-based international system. And there are many reasons to want that, including these quote from Volcker, Rajan and Draghi, OK?
OK, the last thing is this policy rule bill that’s passed the (House) Financial Services Committee, passed the House of Representatives. It’s now part of the CHOICE Act. I think it’s quite important and I’m glad that Eric raised it. So this is actually a proposal I made in 2011. And it was a paper about the proposed legislation. It’s quite different from the actual legislation. You can imagine writing legislation is different than writing a proposal no paper. You got to be a lawyer to do that, for one thing. So it’s different. But maybe think about this: Why did we start thinking about this?
In ’92, we didn’t talk about legislation. This is something that central bankers can find useful to think about. I think what motivated me at least was policy did seem to go off track. We did seem to lose what was working well before 2003, ‘4, and ‘5, one of these very unusual policies. So there’s a reason, and I think the legislation can actually help to normalize policy, which seems to be the intent not just in the U.S. but other countries. I think it’s – it will restore this on a longer-term level. We’re going to have deviations in the future.
And if you can think a little bit about that just as a counterfactual. You don’t know for sure, but imagine that something like this was in place in 2003, and ‘4 and ‘5. Then the chair wouldn’t have to explain why we are a little off, why is the rate still low. Maybe we would have had a good explanation, I don’t know. But it would have discussed I think more publicly. And that would have been good. It’s like the discussion that we’re having more recently. So I think there’s reasons to do this.
The actual legislation – it’s actually called requirements for policy rules for the (Federal Open Market Committee)– it would require that, and I quote, “the Fed would describe the strategy,” strategy’s important here, “strategy or rule of the FOMC for the systematic quantitative adjustment of its instruments.” And so, first of all, it would be the Fed’s job to choose a strategy and describe it. Congress wouldn’t do that. The Fed could change its strategy, it could deviate from it, just explain why. It would describe – it would decide how to describe the policy.
The legislation wants the Fed to compare its strategy with some referenced rule. It could be rules, by the way, it doesn’t have to be one. And people have raised questions about independence, flexibility, how does the committee decide on a strategy, and other things. But it seems to me that this is a productive way to have a better engagement with the Congress and the public about what seems to be going on in many respects.
OK, so just to wrap up, I considered five questions that were part of the agenda, part of the charge. And there are many suggestions and proposals for rules. But if you think about what I just said, almost all of them are based on some kind of models, methodologies, empirical work. It’s not just throwing things out, for the most part. At least, there’s a lot of analysis going on. I think it’s important to continue that. The models are not perfect. They need to be changed. I know the problems pretty well. I know they need to be changed.
But one thing to say is because there’s many proposals does not imply – I’ll read – does not imply we should discard a systematic approach. So in any policy situation I’ve been involved with or I’m aware of, there’s lots of strategies to choose from. Foreign policy, think of all the strategies people are thinking about we should choose now. It’s the job of the policy makers to choose the strategy and explain it and make it work. So this is not unusual, to have different proposals or different strategies. It’s not a reason not to – not to follow the strategy, not to have as best you can.
Second thing: I don’t think rules should be viewed as ways to tie central bankers’ hands. They are meant to help policy makers make better decisions, and also operate in a democracy, and also operate in a global monetary system, where central banks’ decisions affect other central banks. I think it’s important to recognize that research distinguishing between monetary policy from rules is difficult. That demarcation is difficult. But it doesn’t prevent policy makers from internalizing these strategic principles as they make decisions. It’s important for the research to make this distinction as best they can. It is difficult. We’ll find out more about that in this conference. But again, it seems to me it’s still possible to internalize the idea of having a strategy as best as possible.
Research on policy rules has, again, to me, impacted policy in lots of ways. And even the periods of deviation, there’s a sense of going back. I think to the extent there’s a going back that influences the decisions now. And maybe the impact has waxed and waned. I think it’s perhaps coming back, again, based on the evidence that I just showed you. And then, finally, central bank independence is very important. But it hasn’t been enough to prevent these swings back and forth. And so, given that Congress has this responsibility under the Constitution, it seems that some legislation – maybe not exactly what’s out there, some modifications – and then always – the Federal Reserve Act has always been modified with communication and discussion between the Fed and the Congress. So that should not be left out.
Thank you very much. (Applause.)
DONALD KOHN: Thanks, John. Thanks, Eric and Jeff for inviting me to be back here at this podium. I feel like I’ve been here a number of times over the years. This discussion, this conversation I’ve had with John Taylor for probably 30 years’ time – from the hiking trails of Jackson Hole to the witness tables at the House Financial Services Committee. And I’ve gotten an awful lot out of this discussion. And I’ve tried to bring some of it back into the Federal Reserve. So I think some of the emphasis on rules, the discussion of rules within the Federal Reserve, certainly I was a strong backer of that. I think – and obviously you can tell me if I’m wrong – I started putting these thing in the Blue Book in the mid-’90s. So I think there’s definitely a role to be played.
I’m not sure I agree with exactly what the role is with John, but it’s a valuable time to take stock of where we are. There’s the legislation. I also think as we lift off the zero lower bound, the issue of how to adjust that federal-funds rate and the extent to which rules should play in that adjustment becomes, perhaps, a more effective, more cogent kind of discussion. And I would say, I got an awful lot out of reading the paper. It’s a really valuable summary of where we are in the discussion and confronts a lot of the issues that have come up. And I commend it very highly. There’s a lot of overlap between what I’m saying and what Eric said. I’m not sure – I’m not sure how much confidence you can take from that. I take some myself.
I think one of the issues is – to emphasize, as Eric did – is policy makers should be held primarily accountable for achieving their legislative objectives, the so-called dual mandate of maximum employment and stable prices. And they have been granted a lot of independence to do that, instrument independence. And I think accountability for the setting of the instrument is subordinate to accountability for achieving the goal. And so – and John just said this, I’m sure he agrees – the point of the rules and how they fit into policy is whether to – how they might improve achieving the goals, fostering progress towards the objectives, and explaining how that progress is going to be made, because the explanation is very important, helping private agents form their expectations in a stabilizing way and building trust and confidence in the institution. And I think rules as references can be helpful here.
Reading this paper led me to reflect perhaps more deeply on where the lines are and where I disagree. And so a quote from the paper, rules tend to use formulas or equations for the policy instrument at least as a guide – and those underlines are mine, not John’s – when making decisions. Decisions can be described reasonably well by a stable relationship which shows a consistent reaction to observable events. So as I thought about it, I thought perhaps where we differ a bit here is in the degree of presumption that you’re going to follow the rule, and the role of prediction in the rule.
So this – John can tell us whether I’ve mischaracterized him, but I think the way I see John’s view is we look first to an algebraic rule, usually based on a small number of variables. The rule doesn’t vary over time, or not much over time. Deviations from the algebra are unusual, otherwise it wouldn’t be a rule, require a very strong – (inaudible). And you rely on – and he just said this – you rely mostly on the current estimated values of upward inflation gaps and R-star.
In my view algebraic rules are a reference point to be used for thinking about an explaining policy strategy. But in a complex, ever-changing, poorly understood economy, the presumption for following algebra is weak and the appropriate reference rule can change. And monetary policy – good monetary policy will be made with a heavy reliance on tradition. Mike Tyson said: Everyone has a plan until they’re punched in the face. Dwight Eisenhower said: When preparing for battle, I have always found plans are useless. Planning is indispensable.
So I do think we need the role of rules and thinking about the strategy and where you’re going, but it’s the presumption of adherence that I think divides us to some extent. I think the central irony in some of this, the golden age of rules, 1985 to 2003, was a period in which policy makers weren’t trying to follow a rule, right? So certainly, (former Fed Chairman) Alan Greenspan gave several speeches at (the Hoover Institution) – I remember helping write them – about how following a rule, a strong rule would produce suboptimal policy. And my impression is that the FOMC, although there were discussions of rules, we had it in the blue book, it was part of the discussion, they weren’t following it. It was a discretionary policy, but it would adhere to a certain number of principles – certainly the focus on containing and reducing inflation, following the Taylor principle, but not in a rule-based manner. Remember opportunistic disinflation? So if inflation came down, it kind of cemented in there when we were at three, trying to go to two, but there wasn’t a deliberate attempt to go down? So it wasn’t rule-based in that way. There was a lot of attention to output and employment and its potential effects on inflation, but there was a lot of discussion about the measurement of the output gap and the role of the output or unemployment gap in causing inflation, and as certainly not an automatic buy-in to those things. Very conscious of policy lags and a lot of focus on the future. So where were – the incoming data, what were they telling us about where we’d be in six months, a year, a year and a half, two years, and then how would that affect today’s policy setting. So not just looking at today’s things.
And emphasis on risk management. So what sorts of things were we most concerned about? Where would the – missing would cause the most disutility in leaning that way? That’s not really part of the rule. I think Eric pointed that out as well. And a lot of adjustments of the policy setting were perceptions that financial markets had changed, and the translation of a particular federal-funds rate and a particular set of financial conditions had altered over time. So think about the credit crunch in the early ’90s, think about the stock market boom which caused interest rates perhaps to be a little higher than the Taylor rule might have said. Even before 2003 or around that time, the Enron/WorldCom junk bond problems which caused spreads to widen – so there were a constant, constant reassessment of where the policy rule – what the – I’m sorry, what the policy rate would imply for output in employment and then what that would imply for inflation.
And of course, there were committee discussions and a lot of diverse views brought to the table, and I think that helped to enrich the discussion. So I think there were a lot of principles that were being used, and the rules were discussed increasingly over the 1990s, but especially in the first half of that period they weren’t really there. So I guess my question is, why don’t we just say to the policy makers whatever you were doing in ’85-2003, following a set of principles, continue doing that. Don’t obsess on the rule that algebraically, arithmetically describe what you’re doing, but keep doing those things. And I think that’s a strategy. There’s a tendency in this discussion to equate rule and following rule with the word strategy and to say you don’t have a strategy if you don’t have a rule, and I disagree with that. I think you can have certain principles and ways you react, and that’s a strategy.
Eric emphasized the role of changes in these unobservable variables, what’s the potential GDP, the (non-accelerating inflation rate of unemployment), R-star, and they certainly did it in a way of using rules. The relationships are also changing. We’ve already talked to some extent about the relationship of interest rates and the output gap, and we’ve seen a lot of disappointment, particularly early in the recovery from the Great Recession, to how the economy wasn’t responding as much as we thought – we thought it should to very low interest rates, and then recently now a lot of discussion about what the relationship of the output gap to inflation is. So when you have these uncertainties, I think it makes the adherence to algebraic rules produce less than optimal outcomes. One reason that the activities of the FOMC look like rule-based in that ’85 to ’03 period is because it was the period of the great moderation, so-called nice period, as Mervyn King dubbed it. Some of that was caused by better monetary policymaking, but I think there are a lot of other factors involved, too. So I think Watson (sp) had a thing about how there were fewer shocks to the system, et cetera. And so it’s not just monetary policy.
Since then, since 2003, as Eric pointed out, there’s been a lot of – a lot of changes, a lot of differences, the declining R-star, falling productivity growth, huge changes in the financial system and long stretches with policy rates constrained at the effective lower bound that I think made policy rules much less valuable even as guidelines.
So what are the problems that we’re trying to solve with the policy rules? One of course is the ultimate one is poor outcomes, and recently the slow recovery and low inflation. I guess my impression is that since 2008, following many of the rules called for higher interest rates than actually existed, and many of the people who were advocating rules were highly skeptical of (quantitative easing) and I think past the first quantitative easing, first large-scale asset purchases – and I guess my concern would be that if we had been following rules over the last several years, the outcomes for the economy would be worse. Inflation would be lower following many of the rules. Outcomes would be worse, inflation would be lower, unemployment would be higher.
I think a second issue is accountability. And again, to repeat what I said before, I think if you put too much emphasis on rules, you’re focusing accountability in the wrong place. Accountability should be focused on achieving the legislative objectives and explaining how your choices are going to get you there.
And then uncertainty: There’s been some discussion. John didn’t have it in his paper, but he certainly has discussed it before, about how he thought that the Federal Reserve’s actions since the Great Recession created more uncertainty about policy going forward and made it harder for private agents to form expectations. So on the left here is the uncertainty index on monetary policy from Davis et al, and at least to my eye – and the golden age is to the left of the dash line and the bad period is to the right of the dash line – and it looks to me like uncertainty is certainly no greater than it was during the golden age, and probably a little less.
The right-hand chart is the – a survey that Brookings did – I think it was early last year – on how well people understood the Fed’s reaction, how was – how well was the Fed communicating. And you can see the results. I think at least in the markets – so I think most people felt they had at least – they understood it sometimes but not always, and some – and there was a significant amount that thought it was clear or mostly clear. There were people who – particularly academics who had only a vague understanding or didn’t understand the market, which is often complaining about this. The vast majority thought they understood sometimes but not always. So I would say looking at this, there’s room for improvement, but it’s not so awful. So you can always – you can always improve. And that’s where I think rules could be used.
So I do see rules being used to help the Federal Reserve explain what they’re doing, why they’re doing it. I don’t – I think to a considerable extent the Federal Reserve can replicate in the public what it’s doing in private. So as Eric and John described what the FOMC was doing, they were looking at a suite of rules and then talking about where policy was relative to those rules. And I think that – in that way, it’s forcing the Federal Reserve to think about what they’re doing in a different kind of way and to explain it in a different kind of way. And I think rules are very helpful in that regard.
As John noted, there was a box in the monetary policy report that spelled out five different rules and where things were relative to those rules, and I think that was a helpful addition. David Wessel (director of the Hutchins Center on Fiscal and Monetary Policy) and I suggested that about a year and a half ago, I think, and with long and variable lags – (inaudible) – I won’t take credit for it, but I think it was a good way to go.
What was missing from the box, in my mind, was an explanation of why policy had deviated and was deviating from those rules. So it enunciated some principles, as John said, and that was good and showed you where policy was. But it didn’t take advantage. So the whole setup was there for saying, yeah, that’s what a bunch of rules say and here’s where we are, now what factors did we take into account? Why do we think the rules would – that adhering to these rules would have produced less good outcomes than what we did? So I think – I think we could take that box and expand it, and it would be a helpful addition to reducing some of that understand sometimes but not always or don’t understand or have only a vague understanding. So I think it would be helpful to the Federal Reserve and to the public if the Fed used the rules as reference points for a fuller explanation of what it was doing and why it was doing it, and then – and that would be a good addition to monetary policy communication.
Thank you. (Applause.)
MR. TAYLOR: I’ll have a few comments. Thanks, Don, very much for your thoughtful comments.
I agree completely with your last point, that some comparison with the rules out there, strategies out there with the decisions would be good. I think to some extent when I referred to Janet Yellen’s talk earlier this year – it was San Francisco, actually – she did some of that – and so that could be – in a way, that was a strategy. I just quoted it in my talk. It was – it was verbal and it was – but it had many of the features that come close to a strategy.
I think the point about during the term of Volcker and Greenspan, it is interesting how the decisions were made. You know more about it than I do. But it did have a rule-like feature. In fact, when I was in the (Council of Economic Advisers) during some of that time and talking to Alan Greenspan quite a bit, and he actually one time said that the Fed deserves an assist in the Taylor rule. So I think there’s a sense in which that’s the case. So – but it’s definitely true. And the idea that to do what you did in that period is a lesson, is – in a way that’s what we’re talking about. Do what you did then – it worked – and to try to find a way to do that.
I think one – just one last thing. The – I mentioned this as well before. The emphasis about disagreement about rules since 2010 is one thing, but the issue in 2003, ’04 and ’05 is more important to me at this point. There was a sense in which it was always we were going to go back. That was implicit, I think, in a lot of the discussions. But that deviation was huge, in my view, and that’s one of the reasons we’ve been motivated – I’ve been motivated myself to come back to this. But anyway, thank you.
MODERATOR: OK. If you want to make a comment or ask a question, raise your – (inaudible). They’ll come around with a microphone.
Q: Thank you. I’m – (inaudible) – from the Central Bank of Chile.
I wanted to – a little bit more on the distinction that you make or the similarities that you point out with the forecast-based targeting rule. So, in listening to your remarks, I think it’s the notion that these two concepts are not that different. And perhaps you have more information with forecast-based targeting, but also more discretion. And in that sense, from a practical perspective, just a simple rule dominates.
So, yeah, at the Central Bank of Chile we actually follow a forecast-based rule – not all the way – (inaudible) – but to a large extent that’s what we do. And I would argue that in some situations the implication for monetary policy that arises from the Taylor rule, the simple Taylor rule, are actually quite different. And it’s not only a matter of magnitude in a direction, the sign of what we do with policy.
Take the example of 2014 and 2015. We had an important fall in the price of copper. That affected the – (inaudible) – and we had inflationary pressures in Chile. So what did our model said was going to happen in the next year or so? It said, well, inflation will be higher, but eventually, at the two-year horizon, you’re going to have – (inaudible) – output gap, a – (inaudible) – output gap, and you’re going to have lower inflationary pressures. So actually, the forecast-based targeting rule said you have to wait, and actually, you have to start lowering rates. But the Taylor rule basically – the Taylor rule would have said – and it did say – you have to actually raise rates.
If we go to the current situation, it’s the same but the other way around. The Taylor rule says you need to lower rates, where – but our forecast-based rule says you need to wait a little bit because probably six months from now you’re going to start raising rates. So I guess what I’m trying to say is, in many situations current inflation and current output gap is not a sufficient statistic. I would say it’s not even a very good statistic of where we’re going to be in a year and a half to two years from now. So –
MODERATOR: If you could just hand the microphone – thank you.
Q: OK. Lars Svensson. OK, I thought this was a very interesting exchange/discussion between John and Don and to hear them present their very thoughtful arguments. We certainly learned a lot from this discussion. (Off mic.)
I have – I have two questions or comments. First, I think John mentioned that Taylor rules or Taylor-type rules performed reasonably well in those models that we used. I think one reason is that there is a certain model bias in favor of Taylor-type rules in the sense that an optimal policy is normally to respond to all the determinant state variables of your target variables, the target variables, say, inflation and unemployment. In most models, the most important state variables are inflation – and often sometimes the only state variables – then it’s pretty – it’s pretty obvious responding to those two will normally give good outcomes. In the real world, of course, inflation and output is not – are not sufficient bases. There are lots more state variables, information relevant. For instance – (inaudible) – experience. So in the real world, the set of state variables is much larger, and often there’s lots of important information outside current inflation. And those things are usually not in our models.
My second point is that John told at the end about the targeting rules and forecast targeting, and made the point that then you can include more information in determining the forecast, but also that there is some model dependence there. I would actually say that there can be model dependence, but also you can actually incorporate judgment. There’s a lot of information outside our models. You can actually have – in practice, many forecasts have been used in central banking and monetary policy are kind of model averages. You look at the forecast of different models and you take an average of them. So, in a way, you’re taking into account – (inaudible). And the more you think about it, it’s actually taking into account all information that you think is relevant. And in the end, the lack of judgment is not – (inaudible).
MISHKIN: John, one thing that you said that – I actually think is actually not only wrong, but also unfair, that – Ben Bernanke and the whole issue of constrained discretion. And obviously, I’m involved in this because it was Ben and I that coined the term in our discussion of inflation targeting.
When you read what we talked about, both in the initial paper but also the book that we wrote, it’s very, very clear that what we’re talking about is a strategy, and it’s very consistent with some of the principles that you’ve talked about. And I don’t – you know, I could be wrong – I don’t know everything that Ben’s said since we wrote that – but I don’t think it was inconsistent with that view. And in particular, we talked a lot about – in that book and in the paper, we talk a lot about the issue about the need for communication to talk about exactly the things you discussed, which is how are you setting policy today in order to achieve the actual objective of inflation targeting and actually to constrain discretion.
And I’m going to talk a lot about this later on. You’re starting the conference, I’m ending it, so we’ll have a long-running debate over this thing. But I do think that there is an issue that is the case, which is how do we actually improve discretion and constrain discretion? And I think I’m going to talk – that’s something I’m going to talk a lot about later on.
But I really do think it’s absolutely unfair to characterize Ben as thinking that, yes, you talk about a goal, and then you do whatever you want. It’s not consistent with what he said. It’s not consistent with what the Federal Reserve did during this period, which I actually argue that during this period – the issue of the 2003 to 2005 period is a tough one. I happen to agree with you that monetary policy was too easy, and I disagree with Ben on that point when he countered your arguments. I don’t think, however, that that’s the main reason we had the disaster we had. If you’ve studied financial crises, which is – and the history of financial crises, this is a classic; that basically, there was a set of events that occurred – new technologies – this is typical of the way you get financial crises – new technologies, there was an unawareness of how these technologies could be a problem both in the private sector and by regulators, and in that sense the regulators can be blamed. And then it blew up in a disastrous way and brought bad outcomes. And in that sense, I do agree with Ben. But I actually don’t defend – I was unhappy that he defended monetary policy which was, in fact, too easy beforehand.
So I think that, from my perspective, that we better be very careful in terms of terms. And I think the same issue comes up in terms of this format. There’s subtleties involved.
The way you’ve described it actually today I had much less problems with. But I think the reality that we have to understand – and, in fact, the issue of accountability and the need to actually talk about how you set policy instruments in terms of achieving the dual mandate is actually critical in terms of good monetary policy. There are subtleties here in terms of the Act which I really worry about tremendously, in particular that the Congress has this tendency to talk about flip-flopping all the time. Don mentioned this. I think he’s absolutely right. Think about what happened if the format was in place when the Fed had to clearly deviate very strongly from Taylor rules. And, in fact, I would argue that’s exactly one of the reasons why we shouldn’t have rules as something that we have to follow, even if they’re used as guidance. It would admit that the Fed would have been doing something very different, and I can tell you the constraints on the Fed from the political process would have been even worse.
So these are issues that we’re going to debate over the next bunch of days. And so I think that there’s a lot of subtlety here. But I think we have to be very careful in terms of our terms. Constrained discretion, Ben Bernanke was not somebody who was a pure discretion guy. By the way, I happen to agree with you on Larry Summers. Larry is somebody who is a pure discretion guy. And, by the way, at the Federal Reserve, (former Treasury Secretary) Tim Geithner and I had a lot of fighters before the crisis where I was arguing for constrained discretion, more rule-like behavior, and he was not keen on it. But I think that the case of the actual way the Fed acted and the way Ben Bernanke acted, it’s actually completely incorrect to say that he was somebody who was advocating discretion and not being accountable to have a strategy and be very clear about the strategy.
MODERATOR: Go ahead. (Inaudible.)
KAPLAN: OK. And this will build a little bit on the previous comment.
First of all, I think it was a great discussion, and I particularly agree with some of Don Kohn’s recommendations at the end, which sound like there may be a consensus on. The one comment we’ll probably build on (inaudible), it probably makes sense that ’03 to ’05 there were – may have been monetary policy mistakes. For someone who was in the markets at a firm – at a firm at that point, I wonder, though, for the Fed whether the bigger lesson – I guess we’ll get your reaction in the Q&A – the bigger lesson is on macroprudential policy. And I think that’s an important thing for us to think about today. In particular, growth in leverage in the financial system, and particularly the explosion in (credit default swaps), which would have been caught with strong, rigorous stress testing, which we do in fact have today. And some legislation is – wants to dilute that to some extent. I wonder if that’s the bigger lesson from ’03-’05, and so I’ll be curious to hear your reaction to that.
Q: Thank you both for really excellent, excellent comments.
I guess my question is to learn a little bit more on the issue of international versus domestic as the driver. In our very global world, where spillovers tend to come from all kinds of direction(s), looking at current policy and how it’s being determined by current domestic inputs, where the future might be impacted quite substantially if a big trading partner or bloc has a problem, how does that get put into a model versus discretion?
And the related part would be, then, something that was just mentioned in terms of financial spillovers. It’s very, very – so I come from a private-sector background, and I think one of the things that I am particularly keen to hear about is really the financial-sector spillovers that are often not visible right away in the economy but, as we have seen with the large debt that we have across much of the developed world, does show up in very substantial ways down the path. Thank you.
Q: Sure. Charles Lieberman, Advisors Capital Management.
One of the underlying problems here, I think, is the interaction between politics and economics. Congress would like to impose accountability on the Federal Reserve, and that requires rules. Without rules, there can be no accountability. And yet, John Taylor sort of straddles the line between rules and discretion because he recognizes that you can’t impose some rules without some discretion. And yet, of course, that wouldn’t be convenient for Congress. It’s typical of politicians that they want to impose rules, and often those rules are very simplistic. A good example: Dodd-Frank, where Congress tried to impose rules, couldn’t even figure out how to implement them, so they passed the problem along to the various agencies. And I think they would discover again, if they impose any version of the Taylor rule, that they would run into problems and have to allow discretion.
Q: V.V. Chari, University of Minnesota and Federal Reserve Bank of Minneapolis.
I’ll try to keep this short. The substantive point made and a linguistic point I think is actually important. That sounds minor. Let me start with the substantive point.
I think everybody is right. John emphasized this, and he’s exactly right about this: You cannot think about policy as anything other than a strategy, which is a contingent plan of how you are going to choose policy in various situations you might find yourself. There are two important aspects of strategy which are often confused in the way people think about it. One is strategy is my contingent plan for what I will do. And the second is a strategy is also other people’s beliefs about what my contingency plan is. And both of them are important in any dynamic or any interesting situation.
Let me – let me explain. There’s a great scene from “Dr. Strangelove” where the United States has built a doomsday machine which is going to go off if the Russians attack. Unfortunately, they’ve chosen – that’s a strategy – they’ve chosen to keep that secret from the Russians. (Laughter.) And Dr. Strangelove says, what sort of idiots are you? The whole point of building the doomsday machine is to tell the other people you’ve got the doomsday machine!
So once you think about things that way, it’s not particularly important whether the FOMC gathers together and looks at its particular rule and says, oh, are we deviating, are we not deviating. What is critically important is that market participants and private agents and firms and households and everybody else have consistent, sensible beliefs about how you are going to act in the future. And so that is what is going to help.
The relevant question that in Don Kohn – the survey that Don Kohn quoted is not do you think the Fed – do you think you understand the Fed’s reaction function. The relevant question is: Do you all agree on what the Fed’s reaction function is? The proposal at hand, which John has been pushing, I understand it, is to try and reconcile those two notions of strategy. Forget about legislation. Think about a different framework for how the Federal Open Market Committee should make its decisions.
Let’s say every three to five years they get together and they choose a strategy: This is how we are going to react in the future in various contingencies. Obviously, you’re not going to label every contingency. That’s too many pages for anybody to read. You’re going to label the important contingencies. That’s what you’re going to do. Then you – whenever you deviate from it – and you will deviate from it – you have an obligation to explain what you’re doing.
What is the advantage of doing all this? The whole point of doing all this is you communicate to the public at large this is how I am going to behave in the future. Right now we’ve got a whole bunch of really smart people out there in the FOMC, right? Ask anybody in the market – ask any five people in the market, how do you think they’re going to respond to five different – to a couple of different circumstances in the future? I’m willing to put a solid amount of money on the proposition that you are not going to get any agreement at all. That is the world we are currently living in, where I have no idea – or, at least, I have ideas. But my ideas don’t agree with the other guy’s idea on what they’re going to do in the future. So the whole point of this proposal is to enable people to coordinate on how they think the Fed will behave in the future.
I just don’t see how anybody could object at a conceptual level to a straightforward proposal like that. It shifts all the discussion at the FOMC away from silly ideas about should I go up 25 basis points, should I go down 25 basis points, should I stay where I am. What nonsense is this? Because we have no way of using economics to understand that. To a much more focused strategic conversation, which says: How are we going to react in the future? What are we going to communicate about how we’re going to react in the future to changes in circumstances, to changes and shocks? That enables private agents to coordinate on what – coordinate their beliefs.
I think overall, that kind of framework is likely to lead to much better outcomes. That’s what I see, what it is. Reducing the debate to simple notions of should I should I follow the Taylor rule with a coefficient of 0.5 misses the whole point of changing the framework of this country. As far as the minor linguistic point is concerned, even under discretion, the people are going to be believed to be following certain rules. So the discussion is not between rules and discretion. I think (Finn) Kydland and (Edward) Prescott chose the wrong title for their very important and influential paper. I think the real question is one – is the distinction between commitment and no commitment.
Commitment says I choose a strategy and I tell you what strategy I’m going to follow in the future, and I will not deviate from that strategy. Discretion says I’m going to choose a rule which is optimal at each date. That is the difference that I think we should keep in mind. Sorry for having gone on so long.
MR. KOHN: So very briefly, very important comments. I would like to respond to everything, but the comment from – (inaudible) – I agree that the forecast is in principle better, if you can forecast well. And what I learned a lot from your colleague over to your left was that the rules are very helpful for inflation targeting connects. And that’s, in a sense, how they can implement it. So it’s kind of a different approach to rules. And I tend to be worrisome about it, because forecasts are not all that great. And, second, if you have a forecast, is forecast based, the rules are going to be a little different than if you don’t.
So that’s – I think (inaudible) points about the model bias I think are very interesting. In some sense, I think that’s why the simple rules worked in the models. I completely agree. There’s some important things in the models. Now, there is a lot of work with – different kinds of models don’t have that property and they seem to work well. And maybe the world will be different in the future.
MR. TAYLOR: So, (inaudible) and I have discussed this constraint, discretion issue many times. And I maybe over-characterized it. I think there is a difference, which is worthwhile going into. And I think the forecast targeting is more specific about this than pure constraint, discretion. So I agree with Rob very much about the other issues that occurred in 2003, ’4, and ’5. I sometimes say that there were kind of two rules broken.
One was the regulatory rules – a lot of things going on at the financial institutions that probably should have – if we had some policies we could have dealt with, probably should have dealt with them in any case. International spillovers is a big interest of mine now. I’ve written about it as much as much as I can. I’m seeing impacts on exchange rates that I think people were not aware of, and maybe not understand that, because it is part of the international spillover, which is – which is very important.
So just on Jerry’s points, I agree about the fact that this – you want the strategy to be understood by others. That’s a very big part of this. And whether Don’s surveys addressed that or not I don’t know. So I’ll just pass it to him.
MR. KOHN: So I don’t – I don’t think they asked did you all agree on the strategy. But let me make just two points here, or cover two topics. One is the 2003, ’05. And I think, like Rob, I think the regulatory breakdown was much more important than excessive reliance on the private sector to manage – or, to understand and manage the real risks and complacence on the part of both the private sector and the regulators that they were doing a good job. And encapsulated, in some sense, in Basel II, which said: You guys know how to manage your risk. We’re going to rely on your risk – your risk models, which were totally – ended up being totally inadequate.
On the level of interest rates – I litigated this a few years ago at a conference – I think there are reasons why the interest rates at most were only a little too low. We were – depends on which price index you’re looking at. There were changes in financial conditions that affected what the appropriate interest rate was. So I think the regulation’s much more important. But on the interest rates, the thing I regret, John, is that – is the measured pace language. So, it wasn’t so much the level of rates. It was the predictability of the rates. And I think when we started that language in 2004, we didn’t – we didn’t mean it’s going to be a quarter point each meeting, but that’s what it ended up meaning.
And we got into that thing. And perhaps we didn’t – and, frankly, (former Boston Fed president) Cathy Minehan was one of the people who pointed out at FOMC meetings: There’s too much certainty out there. People are doing carry trades. They’re counting on this. And they’re building up positions that they’re going to regret. So I think of the policy – of the monetary policy mistakes we made, the communication mistakes we made, I think was being too predictable rather than being too low and not responding to changing conditions.
And then on (inaudible) points, one problem is anticipating what’s going to happen. So there are so many possible things that could happen. Letting people know how you’d respond to this, that, and the other thing is going to be very, very hard. But I do – there are some – and I think the FOMC is trying to say over the last few years how it might respond to inflation coming in a little faster, a little slower, how it might respond to unemployment. They have the threshold thing on the zero.
So I think they’ve tried to do that. I do think talking about why your interest rate is where it is and the things you considered in getting to that point relevant to, say, some rules, or relevant to, say, previous expectations, will help people understand how you’re going to react to contingencies. You can’t always – and, as I said, rules – you can have a strategy without following the rule. But you should be following some principles that help people know how you’re going to react to unexpected developments. And I think any central bank can always improve on how to enunciate that principles – those principles and how that – those principles got them to where they are.
MR. TAYLOR: OK. So one quick reaction about – the communications in 2004 and ’5, mainly, a little bit in ’3, I agree with you. It’s not just the low rates. It’s the commitment to low rates for a while. And in fact this convinces me –
MR. KOHN: It’s not so much – (inaudible).
MR. TAYLOR: Yeah, exactly. It was the measured pace, absolutely. But it’s a little more than the uncertainty. It’s the certainty it’s going to be low. You know, it’s not just the predictability. It’s not – that the low rates and the statement they would be low for a while together. I completely agree, that was part of the problem.
MODERATOR: OK. So we’ll now take a break.