John Taylor on Inflation, the Fed, and the Taylor Rule

Episode Summary

Executive Summary: Russ Roberts and John Taylor discuss the resurgence of U.S. inflation, defining it as a sustained rise in the average price level and arguing it is primarily a monetary phenomenon. Taylor contends the Fed kept rates too low for too long, deviating from the Taylor rule and risking a sharper future correction, while dismissing supply-chain and greed-based explanations as secondary.

Main Topics: What inflation is and how it is measured: Taylor explains inflation as the change over time in a broad price index, especially the consumer price index, which weights goods by spending shares. He stresses that inflation is about the overall average price level, not isolated price spikes. Why inflation matters: The discussion covers how persistent inflation erodes purchasing power, complicates planning, distorts interest rates, and can undermine the functioning of monetary policy if it becomes unstable or too high. Monetary policy and the quantity theory: Taylor invokes MV=PY and argues that sustained money growth, when output and velocity are relatively stable, leads to higher prices. He says the current inflation surge is closely tied to overly expansionary monetary policy. The Taylor rule and central bank strategy: Taylor argues the Federal Reserve’s short-term policy rate is far below what a rule-based approach would imply given inflation and economic conditions, and says gradual normalization would reduce the risk of a disruptive adjustment. Alternative explanations: supply shocks, greed, and shortages: Roberts presses on supply-chain problems and shortages; Taylor acknowledges relative-price disruptions but argues they do not explain the broad rise in prices. He rejects corporate greed as a coherent explanation for inflation. Fiscal policy, deficits, and stimulus checks: The conversation briefly shifts to large federal deficits and pandemic stimulus payments. Taylor argues the stimulus payments were largely saved rather than spent, so they did not materially boost consumption, though he remains concerned about rising debt. COVID resilience and economic adaptation: Taylor credits the economy’s resilience to technological substitution, remote work, and market flexibility, arguing that the recession and supply disruptions were absorbed better than many expected.

Key Arguments: Inflation is the sustained change in the average price level, not just rising prices in a few goods. The CPI and similar indexes are broad baskets meant to capture economy-wide price movements, though individual experiences differ. A 7% inflation rate is problematic even if steady because it distorts interest rates, weakens planning, and can force harsher Fed tightening later. Taylor argues inflation is fundamentally a monetary phenomenon: if money growth is too high relative to output and velocity, prices rise. Supply-chain bottlenecks and oil shocks explain relative price changes, but not persistent economy-wide inflation without accommodative monetary policy. The Fed’s short-term policy rate has been held near zero despite inflation and recovery, which Taylor says is too expansionary. The Taylor rule offers a simple guide: raise rates when inflation rises and lower them when the economy weakens; current policy is far below that benchmark. Taylor believes gradual rate increases now could avoid a more painful recession-inducing correction later. Large pandemic stimulus checks did not substantially increase consumption because much of the money was saved. The economy’s resilience came partly from remote work and digital tools, not just fiscal stimulus.

Data Points: U.S. CPI inflation (Dec 2020 to Dec 2021): around 7% - Taylor cites the recent year-over-year increase as unusually high and broad-based. Producer Price Index increase: 20% - Taylor mentions PPI as a sign of upstream inflation pressures likely to feed into consumer prices. Fed policy rate expectation for end of year: 0.9% - Taylor says the Fed’s own projections still imply a very low federal funds rate, though higher than the prior 0.3% estimate. Fed policy rate prior projection: 0.3% - Taylor references the Fed’s earlier estimate from the previous September. Fed policy rate during the episode: about 0.1% to 0.15% - Taylor describes the federal funds rate as effectively near zero. Long-run/normal nominal interest rate assumption in Taylor rule: 2% historically; possibly 1% in newer debate - Taylor notes debate over the steady-state neutral rate, but says this does not justify near-zero rates. Real economic growth estimate: around 2.5% - Taylor gives a rough estimate of sustainable real growth during discussion of normal policy. Peak inflation in the 1970s: over 7%, reaching double digits - Used as historical comparison for current inflation concerns. Fiscal stimulus packages discussed: 3 total (2 under Trump, 1 under Biden) - Taylor says these pandemic-era payments did not significantly raise consumption.

Pivotal Quotes: "Inflation is how much that changes over time." — John Taylor: Definition of inflation as the change in the average price level, not a single price increase. "It’s very simple. It’s just a guide for the interest rate to be set." — John Taylor: Explaining the Taylor rule as a rule-of-thumb for monetary policy. "It was not stimulated." — John Taylor: Taylor’s summary of the pandemic stimulus checks, arguing they were mostly saved rather than spent.

Implications: The episode argues that taming inflation requires the Fed to normalize rates sooner rather than later. If policymakers wait, the eventual adjustment could be sharper, risking recession, higher borrowing costs, and more economic distortion.