Former fed chair Ben Bernanke is at it again. In his most recent blog post on the Brookings website, Bernanke takes on critics of the Fed who want to compel the Federal Open Market Committee to follow “rules” that prescribe the steps it should take in specific economic circumstances. Bernanke focuses in particular on the Taylor Rule, and after a long academic discussion, offers a pretty convincing explanation of why a rules-based robot making decisions for the FOMC is a bad idea.
Breaking down the Taylor Rule
The Taylor Rule (named after Stanford economist John Taylor) argues that the federal funds rate should be linked to inflation and GDP. A simple version might say the fed-funds rate would rise by one-half of a percentage point if either inflation minus target rose by a full percentage point, or if output rose by a full percentage point above its potential.
Bernanke decided to modify the Taylor Rule just a little, and discovered that Fed policy was actually quite close to his modified version for more than 25 years from 1990 to 2007.
That said, Bernanke wouldn’t favor the adoption of his modified Taylor Rule. One reason is that the Taylor Rule assumes policy makers know the size of the output gap, i.e., the difference between how fast the economy is growing and how fast it ideally should be growing. Bernanke also says the Taylor Rule assumes the rate when inflation is at the target and output is zero is fixed at 2%, when in reality, both Fed members and the markets perceive the equilibrium funds rate as lower than that.
Moreover, there is no agreement on what the Taylor rule weights on inflation and the output gap should be, except with respect to their signs. Ideally, the weights would respond not only to the changing preferences of policymakers, but also to structural changes in the economy and the “channels of monetary policy transmission.”
Finally, Bernanke notes that the Taylor Rule also does not have a provision for when the predicted rate turns negative, as it has for almost eight years now.
Statement from Bernanke’s blog
Bernanke concludes his blog: “I don’t think we’ll be replacing the FOMC with robots anytime soon. I certainly hope not.”