Scott Sumner writes,

I’m all for a rules-based approach to policy. But unfortunately Taylor fails to make his case. You’d think a fan of rules-based policy would provide a razor sharp critique of Fed policy, but Taylor’s critique is anything but clear

Scott Sumner’s rallying cry is “Target the Forecast!” (for nominal GDP) and John Taylor’s rallying cry is “Follow the Taylor Rule!”

Some remarks:

1. I think I saw the clash between Sumner and Taylor coming even before Sumner did.

2. “Target the Forecast!” is, in a generic sense, what the Fed has been doing since the 1960s. The FOMC discussions revolve around forecasts. Fed staff scrutinize data closely in order to divine what it means for the forecast. Alan Greenspan was an intense and promiscuous data-scrutinizer. Taylor would argue that, until late in his term, Greenspan’s target-the-forecast approach happened to line up with the Taylor rule.

3. What is the result? As Ed Leamer puts it in chapter 15 of Macroeconomic Patterns and Stories,

On the basis of circumstantial evidence, the Federal Reserve Board, by raising rates late in expansions, can take some blame for almost all our recessions.

Below is circumstantial evidence of the sort he describes. See how large moves in the Fed Funds rate tend to lead large moves in the unemployment rate.

4. Leamer also says,

With all these patterns, it is a mystery* whether monetary policy can be said to cause anything or merely reacts to things that would have occurred anyway. But if I felt the need, I could suppress the doubt and tell with confidence the following story.

[Expansions start out with mild inflation. Then price pressures build as the expansion matures] But the Fed fiddles as inflation smolders. The ever-so-gradual increase in inflation is not enough to get the Fed to respond, but like a small brush fire, inflation soon enough gets out of control…By the time the data are in, and the Fed rate-setting committee has deliberated enough to make absolutely sure that it is time to make a change in monetary policy, inflation is burning fiercely and it takes a heavy spray of higher interest rates to put the fire out. That creates an inverted yield curve, a credit crunch** for housing, and an unpleasant recession. Oh, Oh, we’re sorry, say the Fed Governors, who knock down interest rates to try to get housing and the rest of the economy back on their feet.

5. From this historical perspective “target the forecast” is what got us where we are today. Sure, it looks like a great idea now, when we think that the expansion is still not mature and price pressures are still nowhere to be seen. But eventually “target the forecast” will once again result in a failure to change policy in time. We will continue to experience needless, Fed-induced cyclical behavior unless the Fed is lashed to a rule.

6. You might characterize my beliefs as:

Probability that “target the forecast” (using some market prediction for nominal GDP) would stabilize the economy = .15

Probability that “stick to a rule” would stabilize the economy = .10

Probability that monetary policy “merely reacts to what would have occurred anyway” = .75

*The “mystery” arises in part because the Fed only controls the short-term nominal interest rate, and it is the long-term real interest rate that most plausibly drives spending. In chapter 5, Leamer writes,

the interest-rate on the 10-year has a life of its own, sometimes moving with the 3-month rate, but not always. That should make one wonder how much impact the Fed has on the longer-term rates and also wonder how much it matters.

In chapter 15 he says that

long-term interest rates were generally elevating at the ends [of economic expansions since 1960]. Maybe that is what killed off housing. Maybe that would have occurred even if the Fed had not taken action.

**Leamer was writing prior to 2008, when a different sort of credit crunch arose. I will discuss the Leamer credit-crunch model in a subsequent post.