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Global Perspectives: John B. Taylor on the Taylor Rule, Accommodative Policy, Low Interest Rates and Expanded Central Bank Mandates

Mark A. Wynne

November 24, 2020

John B. Taylor is the Mary and Robert Raymond Professor of Economics at Stanford University and also the George P. Shultz Senior Fellow at the Hoover Institution. A distinguished monetary economist, he is the author of the Taylor Rule, which is widely used to guide and evaluate central bank performance.

His public service includes terms on the President’s Council of Economic Advisers as a senior economist in 1976–77 and as a member in 1989–91. He also served as Undersecretary of the Treasury for International Affairs in 2001–05.

Taylor is the recipient of numerous awards, including the Alexander Hamilton Award and the Treasury Distinguished Service Award at the U.S. Treasury, the Medal of the Oriental Republic of Uruguay for his work  resolving that country’s financial crisis in 2002, the Truman Medal for Economic Policy for extraordinary policy contributions and the Bradley Prize for economic research and policy achievements. He was also awarded the Hayek Prize for his book First Principles: Five Keys to Restoring America’s Prosperity and the Adam Smith Award from both the National Association for Business Economics and the Association of Private Enterprise Education.

The Federal Reserve Bank of Dallas recently hosted Taylor as part of the Bank’s Global Perspectives speaker series. This series was launched at the beginning of 2016 with the objective of bringing leaders from the worlds of business, academia and policymaking to the Dallas Fed to share their insights on global, national and regional developments.

Taylor and Dallas Fed President Robert S. Kaplan discussed the origins of the Taylor Rule, the dangers of holding monetary policy too accommodative for too long, the distributional effects of low interest rates and expanded central bank mandates. The following are excerpts from their conversation, edited for clarity, and presented by topic.

On the Origins of the Taylor Rule:

Taylor: It actually goes back a long time. The models I used were dynamic, where things changed over time. In such a setting, you have to have a strategy or at least a rule to deal with it. So, it goes way back 50 years. But then, the question was, what is the best way to do this? You know, Milton Friedman was talking about money growth rules, and there were alternatives. What struck me as most suitable and most realistic and most useful was a rule where the interest rate was the instrument.

Then you had to think, well, what are the key factors? After huge numbers of model simulations and experiments, thinking about what’s realistic, I came up with this idea that, well, we can make it pretty simple if the interest rate rises by a certain amount when inflation rises and then declines by a certain amount when the economy is in a recession. To make it simple, let’s leave everything else out.

Obviously, everything can’t be left out completely. But that was a simple thing. And it caught people’s eyes and imagination very quickly. I was pleased by that. It caused a lot of discussion. What’s wrong with it? And what’s good about it? How does it apply to other countries? This was quite a surprise because I wasn’t thinking about other countries.

It wasn’t easy to decide what the right equilibrium [or natural] interest rate should be back then. No one had done this before. I chose 2 percent real [interest rate] based on some history and some thinking; it was pretty close. And I also chose a target inflation rate of 2 percent, which was long before the Fed had something like that out there. People had begun to talk about it. So, 2 [percent] real interest rate plus 2 [percent] inflation gave you a nominal interest rate of 4 [percent]. That’s how it was originally [in 1992]; interest rates were higher than that. We were still getting rid of inflation. But that that seemed to work pretty well.

Then the question is, how has that changed over time? Well, it’s pretty simple in a way. It just changes the 2 [percent] to 1.5 [percent] or to 1 [percent], and everything else is the same. Why change the degree to which interest rates should change when inflation changes because the natural rate is lower? That’s how I’ve always looked at this issue.

Quite frankly, the 2 percent [inflation target] was not rocket science in the first place. You know, people came up and questioned it. I think probably I was more resistant than I deserved to be. But there’s some value to having a number that people can remember.

The Risks of Being Too Accommodative for Too Long:

The risk is inflation. Inflation will come if you don’t eventually adjust. That doesn’t mean right now, but it means later next year or the year after. I think [what’s] more important now is the extra search for a yield that occurs, the extra risk-taking.

I think that experience has shown that when you deviate from a strategy or rule, there are problems. [fellow Hoover Institution economist and former Secretary of State] George Shultz and I just finished a book [Choose Economic Freedom: Enduring Policy Lessons from the 1970s and 1980s] reminding people of what happened in the ’70s when there was no sense of a rule or strategy and your [Fed] predecessors got off track big time. But then, [Fed Chairman] Paul Volcker came in and changed things, and the Fed got back to a more reasonable policy, and it worked pretty well.

It just makes sense to have a sense of where we’re going. What’s the strategy? Sometimes, I say it’s good to have a target for inflation. It’s good to have some notion of what unemployment is. But the strategy is maybe more important than both. If you don’t have a sense of what you are going to do with interest rates, say, or even asset purchases, what they respond to, you’re not really describing what the policy is. If you have a dynamic economy—which is changing over time, especially in this international world where there are many central banks—you’re much better off describing as close as you can what the strategy is rather than just deciding on the interest rate.

I think it doesn’t have to be as precise as people sometimes think. The so-called Taylor Rule was a mathematical formula. You can write it down and you can look at it, you could debate it. Actually, that’s one of the attractive features of it. There’s been work at the [Federal Reserve] Board and elsewhere using models with rules in them. They do it all the time. That’s good. You can evaluate it.

It doesn’t mean that the policy has to be exactly like that, and there are other issues that come into play. I think it’s like any kind of strategy—whether it’s foreign policy or a regulatory strategy—you can describe what it is, and you can use the mathematical formula to help you debate what’s right or not, but it doesn’t have to be that precise.

The Distributional Effects of Persistently Low Interest Rates:

I think this is something that we probably need more research on. I think there’s been a danger of certain sectors benefiting from the low rates versus the high rates. And it’s not always a story of rich people or poor people. If rates are going to be zero forever, then that’s going to affect the income of people who save. They’re not going to always be able to have the reward that they should be having.

That worries me in terms of a distribution effect. That [impact of low rates] wouldn’t be the reason I would focus on so much. I think that distribution issues are huge, by the way, in this country. I think that the coronavirus has revealed a lot of income disparity that people knew about but didn’t talk about. And I think we need to focus on that a lot. A part of it is education. A part of it is just basic services. But I would say in terms of income distribution—the low rates—I think there are more important reasons to get those to a reasonable level than income distribution.

What we should do as much as we can is use other means [to address income distribution]. I’m in the education business, so I see a huge disparity in K–12 in the state of California and other places. I hope we fix that part because, believe me, this income distribution effect we’re seeing right now is just really terrible.

On Expanded Central Bank Mandates:

I think it’s very important for the central bank to maintain its independence and to have somewhat limited focus. You can’t do everything. There are talks about environmental issues now at central banks, and a question about income distribution just came up. But I think the more institutions like central banks can focus on inflation; on the stability of the overall economy; keeping inflation low, 2 percent; keeping unemployment close to the natural level, they’re better off. They can’t do everything, and I think to the extent central banks are trying to do other things or trying to go beyond their specifics, that’s dangerous.

We had a few disagreements in the ’70s about policy, and that changed. It didn’t disappear in the ’80s, but monetary policy became more focused in the midst of a very contentious debate about all kinds of policies. There is a huge tendency to think that if we can’t do something by regular means, we have to have the central bank do it.

I think it’s important not to go in that direction. Central banks have an awfully tough job the way it is now describing what they can do and what they can’t do. It’s a very important job. It’s crucial to get it right and not to have many other responsibilities at the same time.

About the Author

Mark A. Wynne

Wynne is vice president and associate director of research in the Research Department at the Federal Reserve Bank of Dallas.

The views expressed are those of the author and should not be attributed to the Federal Reserve Bank of Dallas or the Federal Reserve System.

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