How the Fed Could Change

According to reports Friday, President Trump is expected to announce his choice for Fed Chair sometime next week. Sources in the White House say the list of candidates has been narrowed down to three, current Fed Chair Janet Yellen, Fed Governor Jerome Powell and Stanford University economics professor John Taylor.

The “Taylor Rule”, named after the same Taylor who is being considered by President Trump, was first introduced in an academic paper in 1993 as a hands off approach to monetary policy. If the paper had been written in 2017 instead of 1993, I’m sure it would have been given the name “Robo Fed Chair” or “AI Monetary Policy”, but despite its boring name it has received plenty of attention since it was written and even more so since John Taylor was first rumored to be considered for the top job in the field.

The Taylor Rule is a simple equation. For each percentage point that inflation is below target, Fed Funds should be lowered by .5%, and for each percentage point that GDP is below its target, Fed Funds should be lowered by .5%. Both measures work in the other direction too, (higher inflation and GDP cause higher Fed Funds rates). In the simplest form of the equation, the neutral rate for Fed Funds is 2% and the target for inflation is 2%.

John Taylor was vocal during the financial crisis and the period immediately after, arguing that low interest rates persisting for too long was the main cause of the housing bubble. He presented his model (shown below) that would have been more aggressive in raising interest rates from 2002 to 2006.

As the saying goes, the best strategy for a rain dance is to wait for it to start raining and then start dancing. There may be a bit of that going on with Taylor’s claim that his model would have been better, but abnormally low levels of interest rates do distort asset prices and bubbles are very difficult to predict until it’s too late. But Taylor’s model does limit the influence of politics and other human biases that unfortunately work their way into monetary policy.

Policy makers use the Taylor Rule as one of many guides to how monetary policy should be set, but most have stopped far short of saying it provides a standalone solution to setting interest rates. Arguments against using the rule that way are plentiful.

For instance, in order for the rule to work, two major assumptions must be made. First, what is the neutral rate for Fed Funds? Opinions on that differ big time and they are also not constant. The equation also doesn’t work without a defined level of potential GDP. The rule adjusts Fed Funds based on the “output gap”, or the difference between what GDP is and what it should be. You can see how these could present problems during an FOMC meeting.

Another issue is the definition of inflation, of which there are many. Taylor’s guidelines prefer the use of the GDP price deflator that includes things like price inflation on government outlays and excludes import price inflation. Past chair┬áBen Bernanke┬ápresented an alternate calculation of the rule using CPI and found that rates would have gone far below zero after the crisis and remained below zero until only recently. A phenomenon he argues is not feasible.

We expect to know who will lead the Fed by this time next week, but even if John Taylor is chosen it’s unlikely that he will turn FOMC meetings into poker games while his algorithm does the work of the entire committee. If he is chosen I would expect for the Taylor Rule to still be just one of many tools used by the committee but policy would most likely turn more hawkish.