Tinker, Taylor

In session 8 we explored a link between GDP spending and real interest rates called the IS curve.

It turned out that “IS” was a misnomer and would be better described as a WJ curve – the combination of output gaps and real interest rates where planned withdrawals W and planned injections J are (possibly only temporarily) in alignment.

In session 10 we look at another curve – often called the MP (monetary policy) or TR (Taylor Rule) curve. Like the IS curve it describes potential balancing acts of real interest rates and output gaps, but this time from the perspective of financial rather than non-financial products.

Unfortunately, like the IS curve, the name attached to our new line is also misleading. We are given the impression that the MP/TR curve is all about monetary policy and is primarily pushed around by central banks.

For sure, central banks play a role in guiding the economy’s interest rate/activity mix towards more friendly levels than what unsupervised markets might deliver. However, it is worth emphasising once again that real interest rates comprise three elements:

  • a nominal policy rate (such as the fed funds rate)
  • inflation expectations
  • market risk premia

The central bank has most control over the first – the fed funds rate. Yet, even here, there can be exceptions. This became evident in the GFC when, for all practical purposes, the Fed could not reduce the rate below its Zero Lower Bound (ZLB). Moreover, with evidence that r-star is much lower than previously thought, this problem might well become more frequent going forward.

In contrast, inflation expectations and risk premia are subject to market vagaries and sentiment swings. Clearly these are not levers that a central bank can easily pull. Yet we should not be too disheartened. The GFC and its aftermath illustrated that the Fed (and Government) can gain traction in these areas if they work together, bolster confidence and enjoy credibility. The economy at large will then take on board that the State machinery will “do whatever it takes” to restore normality.

Such mind games require deploying the “dark arts” of central banking – forward guidance, communications, QE shock and awe. But to be credible, they also require governmental co-operation – supportive fiscal policy, new legal frameworks, recapitalisations. Central banks can do a lot more than just tinker with interest rates but they are not all-powerful.

So where does this leave us and our new-found MP/TR curve? Certainly we shall need to tread carefully. The mechanistic Taylor Rule, adopted by many a textbook, cannot be taken too seriously with its dependence – explicit or implicit – on imperfectly measured and/or dubious concepts such as output gaps, Phillips Curves and natural real interest rates.

And surely the Taylor Rule is too narrowly focused. As well as monetary stability, central banks are charged with the task of financial stability, seeking to ensure the integrity of the banking and payments system. The Taylor Rule has nothing to say about credit growth, lending standards, asset prices, capital adequacy – all vital if benign business and financial conditions are to co-exist. No surprise then there was some nervousness in 2017 about the potential appointment of John Taylor to the Fed.

More fundamentally, the benefits of inflation targeting in ZLB-infested waters have also come under scrutiny. Ben Bernanke’s suggestion about temporary price level targets looks interesting and has been considered before. The FRB San Francisco’s John Williams has also weighed in about the need for more policy space. Going further, more commentators are coming round to the view that we ask too much of monetary policy. Ideally, fiscal and structural policies are available to take a supportive role, provided – as we learnt in Session 9 – that there is sufficient debt space to do so.

4 Apr 2019