02 - John Taylor on the Taylor Rule, the 2008 Crisis, and Fed Reform

Episode Summary

Executive Summary: John Taylor explains how his Taylor Rule provides a simple, rule-based guide for central banks to set interest rates using inflation and the output gap, and argues it helps explain the Great Inflation, Great Moderation, the 2000s boom, and the post-crisis era. He defends more systematic monetary policy, criticizes ad hoc discretion and large-scale QE, and supports legislation requiring the Fed to disclose its policy strategy.

Main Topics: The Taylor Rule as a monetary policy guide: Taylor describes the rule as a simple procedure linking interest-rate settings to inflation and economic slack, emphasizing its usefulness for communication and comparison across time and countries. How the Taylor Rule was developed: Taylor explains that the rule emerged gradually from studying policy rules in undergraduate and graduate work, then simplifying complicated model-based rules into a practical benchmark. Great Inflation vs. Great Moderation: The discussion contrasts the discretionary, stop-go policy of the 1960s and 1970s with the more rule-like policy of the Volcker/Greenspan era, which aligned more closely with the Taylor Rule. Debates over measurement and alternative rules: Taylor responds to critiques and variations, including Yellen’s alternative formulation, Rudebusch’s unemployment-based version, and Orphanides’ real-time information problem argument. The 2000s, housing boom, and global spillovers: Taylor argues the Fed kept rates too low for too long in the early 2000s and that global capital flows and dollar pegs amplified U.S. policy spillovers worldwide. The financial crisis and QE: He says the 2008 crisis was worsened by delayed policy response and chaotic bank bailout actions, and he is skeptical that QE2/QE3 meaningfully improved the economy. Rules versus discretion and the FORM Act: Taylor advocates legislation requiring the Fed to report its policy strategy/rule, arguing that transparency and rule-like behavior would improve communication and outcomes.

Key Arguments: The Taylor Rule is valuable because it gives a simple, quantitative benchmark for how central banks should adjust rates when inflation or output conditions change. Taylor says the rule was not a sudden discovery but the result of years of thinking, modeling, and simplifying overly complex policy prescriptions into something usable in practice. The Great Inflation is better explained by poor discretionary policy than by measurement error alone; real-time officials also embraced flawed ideas like the old Phillips curve, wage-price controls, and cost-push thinking. The Great Moderation period is consistent with more rule-based monetary policy, suggesting better policy contributed to improved macroeconomic stability. Orphanides’ real-time output-gap critique highlights uncertainty, but Taylor rejects the idea that it fully explains 1970s policy errors. The early-2000s low-rate policy likely helped fuel the housing boom; Taylor accepts arguments that productivity growth may have played a role, but still sees rates as too low for too long. Global savings-glut explanations are incomplete; Taylor argues much of the international demand for safe assets and low long-term rates reflected U.S. monetary policy and foreign central bank responses, especially under dollar pegs. QE1 was mainly a liquidity response during crisis conditions, but QE2 and QE3 were, in Taylor’s view, not clearly effective for the real economy or term structure. The Fed’s post-crisis strategy was too ad hoc; rules-based policy would improve predictability, reduce market confusion, and help both domestic and global stability. A law like the FORM Act would not bind the Fed to a mechanical formula; it would simply require the Fed to explain its strategy and deviations, improving transparency and accountability.

Data Points: Taylor Rule inflation response coefficient: 1.5 - Taylor explains the original rule implies a 1.5 response to the inflation rate itself. Taylor Rule output-gap coefficient: 0.5 - Original 1993 rule places a 0.5 weight on the output gap. Assumed equilibrium real federal funds rate: 2% - Taylor says the original rule assumed a 2% real neutral rate. Assumed inflation target: 2% - Taylor notes the rule used a 2% inflation assumption, giving a 4% steady-state nominal rate. Steady-state nominal federal funds rate: 4% - Derived from 2% real rate plus 2% inflation target in the original rule. U.S. inflation peak in early 1980s: close to 15% - Used to illustrate the severity of the Great Inflation period. Core PCE inflation since the crisis: about 1.5% on average - Taylor notes inflation has remained below the Fed’s target for years after the crisis. QE liquidity balance-sheet expansion: about 800 billion - Taylor distinguishes crisis liquidity facilities from later QE and says the balance sheet expansion was then unusually large. Household/fed rate change timing: April 2008 to October 2008 - Referenced in discussion of the Fed’s slower-than-desired response before the financial crash intensified. Reference to policy-rule legislation: 1977 and 2000 - Taylor cites the earlier requirement to report money-growth ranges and its later removal as precedent for the FORM Act. Great Inflation period: mid-1960s to early 1980s - The episode Taylor says was marked by discretionary, stop-go policy and poor macro outcomes. Great Moderation period: post-Volcker through the 1990s/early 2000s - Described as a time when Fed policy tracked the Taylor Rule more closely.

Pivotal Quotes: "It's a guideline or a procedure for central banks to follow to determine what their interest rate settings should be." — John Taylor: Taylor defines the Taylor Rule at the start of the discussion. "I think the answer to this is pretty simple we get back to a rules based policy like seemed to work in the past quite well but not just the U.S." — John Taylor: Taylor argues for rule-based policy in response to global spillovers and ad hoc central bank actions. "monetary policy rules work and discretion doesn't" — John Taylor: The title and central claim of Taylor’s 2012 lecture referenced in the conversation.

Implications: The episode argues for more transparent, rule-based central banking and caution with discretionary easing/QE. For listeners, it frames inflation, recessions, and global spillovers as partly products of policy design, not just shocks.