John Taylor on monetary policy

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Here is a review of John Taylor's new book on the financial crisis: "Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis". I complain that it is too short and too tightly focused on the issue that Taylor sees as most important, namely the Fed's too-easy monetary policy in the years leading up to the breakdown. On the other hand, since many commentators ignore that issue almost entirely, you might say he is just redressing the balance. In any event, it's good, and I recommend it highly.

The literature on the causes of the economic breakdown will soon be vast. Amid the stacks, this new book by John Taylor, Stanford professor and author of the celebrated Taylor rule of monetary policy, is worth noticing. It combines seriousness, brevity and accessibility - and it advances a distinctive argument. Its theme is that monetary policy errors, rather than "any inherent instability of the private economy", first caused the crisis and then made it worse.

Unsurprisingly, the Taylor rule has a central role in the analysis. The author has long expounded the view that predictable, rules-based economic policy gets better results than an approach that surprises economic agents or leaves them guessing about what the government intends. The Taylor rule was originally intended as a recommendation to central banks about the conduct of monetary policy and later recognised as a way to predict how central banks actually behave.

The rule says central banks should set the short-term interest rate equal to one-and-a-half times the inflation rate; plus half of the gap between actual and trend gross domestic product; plus one. For example, if the inflation rate is 5 per cent and the output gap 3 per cent, the Taylor rule says make the interest rate 10 per cent: one-and-a-half times 5, plus a half of 3, plus 1. The rule is derived from monetary-policy models that describe how the economy reacts to changes in interest rates. By the late 1980s and early 1990s, the US Federal Reserve was observed to be following the rule, with notable success.

The crisis that began in 2007 and worsened in 2008 was caused, Taylor says, because the Fed abandoned the rule earlier in the decade. Between 2002 and 2004 interest rates were cut even though the rule required them to be raised. In 2004 and 2005 the gap between the actual and the recommended interest rate was between two and three percentage points. Taylor describes a model simulation in which interest rates followed the Taylor-rule path during this period instead of diverging from it so markedly. The housing boom would have ended in 2003 instead of 2006, he says; house prices and levels of mortgage debt would not have risen so high. In short, monetary policy was the primary cause of the boom and subsequent bust.

The rest of the review is here.

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