Monetary economics, the Taylor Rule, fiscal policy, and economic growth

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>> John Hartley: This is the Capitalism and Freedom in the 21st century podcast where we talk about economics, markets and public policy. I'm John Hartley, your host.

Today, I'm joined by John Taylor, who is the Mary and Robert Raymond professor of economics at Stanford University. John is also a senior fellow at the Hoover Institution and is one of the world's greatest living monetary economists. John is also the inventor of the Taylor rule, which is a canonical description of how central banks change interest rates in response to inflation and output gaps.

He is also one of the founders of the new Keynesian macroeconomic paradigm and is consistently cited as a likely future winner of the Nobel Prize in economics, which I think would be more than well-deserved. John has also served in many positions in government. He has served in the US Navy.

He has also served in the White House Council of Economic advisors, and he served as the US treasury under-secretary of international affairs during the George W Bush administration. Welcome, John.

>> John Taylor: Good to be here, thank you.

>> John Hartley: You were born in Yonkers, New York. You're a Princeton undergrad, you're a Stanford PhD.

How do you get interested in economics the first place? And what influenced you to get into the field of monetary economics?

>> John Taylor: Well, I majored in economics in college. I went to Princeton and had some advisors, Phil Howard for example, who just encouraged looking at the overall, the macroeconomy.

And that interested me from the start, and not so much that that's what I was gonna do. But I had to do a senior thesis, I did my senior thesis-

>> John Hartley: It's required at Princeton-.

>> John Taylor: Required, yes, required. And so I did it in that particular topic and that sort of got me interested, and I went to graduate school at Stanford.

After that, actually I had a little interruption in the Navy, went to the Navy in between Princeton coming out here, which was formative for sure. Then came back here, and I was interested in econometrics, actually. Ted Anderson was my advisor, he's since passed away. He's a great advisor and did econometrics.

But that was more on my way to study monetary. I never really lost the interest in monetary economics and how you could smooth the business cycle, how you could have a better economic policy.

>> John Hartley: Fantastic, and I'm curious, so you've been a professor at Stanford for some time.

I'm curious, how did some of these collaborations, for example, in the early new Keynesian days, folks like Ned Phelps, for example. I think one of the biggest, I think, contributions, I think that you made to the new Keynesian literature was coming up with this idea of having a monetary policy rule, would later be named a Taylor rule.

And initially it was sort of used as this third equation to allow for the determinacy of equilibrium. And it turned out later, great description of the world and how the Fed actually would follow monetary policy when it would follow interest rate targets and prescription for optimal policy later.

But I'm curious, how did you get interested in this idea of central banks should be following interest rate targets instead of just, say, money growth rule targets. Things that obviously Milton Friedman was a big fan and proponent of, and certainly captured a lot of the Fed's interest in the 1970s and 80s.

How did you fall into this conversation about following interest rate targets, and how did that interest you in the early new Keynesian days?

>> John Taylor: Well, it came very gradually. It was originally built and was interested in econometric models. They were quite elaborate. They did have this mixture of expectations and sticky prices, which I thought was very important.

And that was a way to both have the ability to affect expectations of future prices, but also have some rigidities, which still seems to be an important aspect of the economy. So those are the basic structure, which was fundamental. But in that context, you have to have a model of policy.

And of course, Milton Friedman was a great influence. And the idea of having a money growth rule, having a rule is essential. How do you study policy without some kind of notion of what the central bank is gonna do next year, next quarter? Cuz expectations are so important.

You had to build on expectations, and you build them in by somehow having a description of what the central bank will do.

>> John Hartley: Something that Sergeant and Lucas and the rational expectations, microfinance models sort of came in the 70s and 80s-.

>> John Taylor: Yeah, in some sense they never had sticky prices.

That was a huge difference. They had perfectly flexible prices. And so what I thought was important, based on my studies, and in looking at the world is some kind of rigidity but not permanent, something that could be influenced by policy, you could do it. So that's why a rule became important, a strategy, before the central bank became important.

And I really began to look at that, but it's gradual over time. You had to have some stipulation of what the central bank was gonna do, what the fiscal policy would do. Otherwise, how would you have a model if you didn't have some description? So early on it was a description, and that gradually evolved to some description where the primary variable which the central bank had influence on was the interest rate and that affected the money supply.

We always had a money demand function in these models. That was still a very important part of it. But I thought, based on my experience in Washington, I worked on the CEA a couple of times, and you could see they became good friends with the policymakers. You could see that their focus was more on the interest rate.

So I wanted to find a way to do that, but to preserve the notion of a policy rule, of a strategy that the central bank was considering. So it was a gradual thing over time, but it involved research in academia and then getting my PhD, of course. But go and work in the Council of Economic Advisors in Washington, coming back and doing more work and going back again.

That mixture back and forth is very important. I had four stints in the government, if you count the navy.

>> John Hartley: That's fantastic, I wanna get back to that a little bit later when talking about the fiscal outlook, but sticking to monetary policy just for a second here. How exactly did the Taylor rule come about?

There's this, obviously, your famous 1993 paper, Discretion Versus Policy Rules and Practice. It famously has a coefficient of, I think, 0.5 on the upward gap and 1.5 on inflation, which I think became, I think, your most cited paper. And it's been an incredible description of the world and something that central banks all over the world Pay attention to closely when thinking about what monetary policy should be, even if perhaps they don't follow it as closely as they should at times.

How did this idea come about to write that 1993 paper?

>> John Taylor: Well, it wasn't instant. It took a while by the way, it's 30 years old as we speak.

>> John Hartley: Yeah, exactly 30th anniversary.

>> John Taylor: Originally, it didn't set out to write a simple, but if you had a, if you looked at policy, it was complicated and isn't there a way we could make it simpler?

And that was what I strived for. I didn't know it become as useful or as popular as it's become global. It's well known. It was mainly a method to simplify in a way that people could understand and you could talk about it. And as you say, the coefficients 1.5 and 0.5.

What could be simpler than that? Just two variables, the inflation rate and the GDP gap, so to speak. And that was the, it was looking around. I didn't start there, for sure, had more complicated things, but that seemed to work pretty well in the models. Remember this, I came about this through the models.

First, make sure that your policy was gonna work in the model, and you had a criterion. You wanted to have low inflation rate, around 2% or so. That was the goal. That was the 2% target, I think was the first time maybe one of the central bank had 2% before then.

But the simple, sometimes we thought maybe one and a half wouldn't be better just choose an easy number and then work from there. And then originally, it was more complicated things. The exchange rate was certainly a factor that people talked about, so I considered that. But it's realized you come pretty close to optimal policy, pretty close to the more complicated thing, which had 30 variables, or ten variables on the right hand side.

He had two, and that was kind of an eye opener for me. But I still thought it was something that wouldn't have as much impact as it has.

>> John Hartley: Well, it's amazing. I feel like it's like one of those strokes of brilliance and genius that you look back on it now, 30 years later, and it's, well, isn't that obvious?

Unemployment, inflation is probably the dual mandate, but I think it's one of those things where it was probably not at all obvious at the time that the Fed could follow these things so closely. And the way that you wrote down the Taylor rule and something that obviously influenced central banks around the world.

Now I want to start getting a little bit to see a question of optimal policy. And I think this is where I think there's a lot of maybe confusion about, and sometimes criticism about the Taylor rules being something that, yeah, it was too rigid to follow mechanically. And where I think people say things, we shouldn't adopt a Taylor rule.

Well, I think that the irony is that several banks around the world have already adopted Taylor rules, and you can just see that in the data. But I think one sort of misconception is that you advocate for something that's strictly mechanical. If you look to, for example, things like the Fed Oversight and Reform Act, the Form Act from 2016, something which you had direct influence on and was something that was before by Congress.

I think that stipulated that Congress could revise these rules and that there wouldn't necessarily be such a mechanical thing. I'm curious, how has your time in Washington when you visit talking with Congress people and talking with monetary policymakers? I mean, how do you respond to those sorts of critics who argue that monetary policy should be not somewhat rules based in a sense?

I'm curious.

>> John Taylor: Well, let me say, the idea of a rules based policy has always been very important. In other words, how are you gonna figure out what the central bank is going to do next year without some kind of a description of what they do? So the notion of a rule, whether it's simple or complicated, was essential to what I was always interested way back at the very beginning.

And the idea that, well, it's too complicated out of five variables came from working in Washington, knowing people at the Fed, knowing Greenspan. He was the chair of the CEA for a while. And so you got the sense a little bit what they were thinking about and how you could simplify it.

And clearly, you had some notion of inflation. If you had a target inflation rate, 2%, then you had some sense to tighten policy when inflation got to Irish policy, when inflation got too low. So that became a key ingredient. But you also notice that, well, the central bank also looks at the state of the economy.

What's the unemployment rate, what's the GDP gap? And so you had to have something in that. And that wouldn't make sense if you didn't, because the Fed is gonna ease when the economy is in a tough time. And then the other variables you maybe want to include, too, as I mentioned, the exchange rate was very common, especially for economies where international trade and foreign exchange are very important.

So I definitely considered that a lot. But the idea, I guess, was you had to have something simpler. And I knew that from working in Washington several times and knowing central bankers in the US and other places. And that's where the idea of, as you say, simple and people always argue is too simple.

How could policy be so simple as two variables? But it's turned out to be pretty good, by the way, it's not always. Sometimes they get off, and I think the Fed recently has been off. Now they're back on again, closer at least. And so people are looking back, well, what was wrong?

And they were so far off. And maybe that's problem. Maybe that will bring even more attention back to some kind of a simple rule. I've noticed a lot of interest. You mentioned the Congress having quite a bit of interest in this, and there was some legislation passed. The Fed had to say what its rule was and the Congress would build into their testimony but that faded away.

I don't know, maybe they come back now, people will see how useful it actually is.

>> John Hartley: Jumping off that, I want to touch a little bit about the Taylor principle, this idea that the Fed needs to raise short term interest rates more than one for one with inflation.

This goes back to the Taylor rule coefficient of 1.5 on inflation. There's certainly been this experiment that's been playing out, and others like John Cochran, have written a bit about this question about neoficarianism and so forth. And in this era of inflation, sort of maybe peaked at 8% or so, and it's still at 6%.

Do we actually need to raise the Fed funds rate to above inflation to get it to come down? And it increasingly seems like that's the case, and that's where we're getting to. And interest rates are, as of this moment, around 5%. I'm curious, what are your thoughts on that debate right now and where monetary policy currently is?

Do you think the Fed has been too slow to respond to inflation? That picked up in May 2021 and became certainly more than just a temporary phenomenon as it became increasingly clear over time. How do you think the Fed has been? How would you assess the Fed's response to this early 2020s inflation?

 

>> John Taylor: In fact, we had a book on the desk here how monetary policy got behind the curve, which was a really important thing.

>> John Hartley: And this is the summary of your monetary policy conference proceedings from last year.

>> John Taylor: A lot of people contributed this, but they were behind, no question interest rate was 25 basis points, and the rules would say it should be four or five or something like that.

So they have way. Quite a way to catch up, and they're now four and a half or so, but I still think based on the rule they got to go a little higher. And you could say, why one and a half? The idea is to have the real interest rate a little bit higher than normal.

So that would offset the other impacts that are keeping inflation from high, basically to attenuate. It's also very important that this be known, as long as it's known, the impact are much less severe. The worst thing is, I'm surprised, tightening, surprised, and that is conjecture. So the whole idea of a rule or strategy is that people know what it is, and it's also important internationally.

So the US knows what's happening in Japan or Europe, and so they have a sense of what's going on there. So I think ultimately, this is always meant to be an international aspect. That's why I've always worried about the exchange rate, but it seems like the US exchange rate is less important.

And also let me say this, it's very important to say, I originally said, this is a guideline, don't follow this exactly. There's other things that come in play, you go back and read my 30 year old paper or whatever it is, you can see that pretty clear now, it is.

Now it's become more adopted, more descriptive of what actually happens, as you say, and that's become an important way to test it. Now we have how other central banks are doing and what they don't go, they didn't follow this method in the 70s, and inflation went through the roof.

And then they've been better at it, we'll see what happens now. There's a real question about what's happening in monetary policy right now.

>> John Hartley: Absolutely, I wanna jump a little bit to fiscal policy and talking to get your thoughts on that, you've long spoken about fiscal issues in the US.

You testified on these issues and you've written several papers and books on this topic. You also served as Secretary for International Affairs, you ran OIA, or Office of International Affairs at Treasury in the early 2000s. You spent time at CEA, and you've also served in the military, so you've seen the government spending side at work very up close.

I'm curious, what do you think about the long-term fiscal outlook for the US? This COVID era spending is piled on an additional four plus trillion dollars in spending. There's right now some negotiations in DC about raising the debt limit, I think it's something that seems to get lifted every few years.

About ten years ago there was this big sort of discussion around Bowles Simpson, the Bowles-Simpson Commission. There's a lot of discussions about debt then, that seems to have become a bygone era almost at this point. With, I think very few politicians in both parties wanting to talk about sort of the reality of entitlement spending and the future path of debt.

We also have inflation and interest rates would, it obviously influenced the net interest costs. I'm curious, what do you think about the fiscal outlook for the US and what do you think needs to be done?

>> John Taylor: So, first of all, I think, we talked about monetary policy, that's where the Taylor rule and things like that come from.

Because I thought it was so important to have something that was better than a fixed money growth rule, but had the same principles as a rule. But there's other rules, there's fiscal rules, there's rules for regulation, there's international rules. I always have written about, this is just one element of good policy.

We have to have a good fiscal policy, have good regulatory policy, a good international policy. So fiscal policy is a very important part of this. And I think that originally, the notion is you had a balanced budget normal times, and you had surpluses and deficits around that. We're far from that at this point at this point.

And I think it would be easier for monetary policy, it'd be easier for policy all around if fiscal policy also had this notion of a smaller deficit. And the deficit has been quite big. And to some extent, it's really like monetary policy being off, they're both off. And I think that the more we can come back to the basic elements of what good economic policy is, and rules base is part of it, and you have a fiscal rule, it really makes a difference.

So there's lots of problems with big deficits, sometimes there, like the panic we had a few years ago, you had to have it, it's there already, interest rates driven near to zero. But the idea is in normal times you don't need that, you should get out of it.

So I would like to see policy, fiscal policy, as well as monetary policy, get back to a more normal stance. I think policy would work better if that was the case. And there's also international aspects of fiscal policy too.

>> John Hartley: Absolutely, I mean, it's interesting to see Europe obviously has tried to adopt fiscal rules and trying to get its fiscal house in order.

Do you have any, on the international side of things, do you have any particular thoughts about the European experiment with the Euro and having a monetary union, but not a fiscal union?

>> John Taylor: Well, I think that their decision to have a single currency was a good one. They had to rein in certain countries and have sort of a common policy of all, it was hard to do, but I think it's led to better policy, I think they're a little bit off right now, to be sure.

I think it's a good system. The UK is not part of it, and so ultimately, I think that's a good way to think about how the world will work. These are countries who are quite different, Italy and Germany, for example. But the idea of bringing them together with a common framework always seem to be good.

And whether it's a Taylor rule or some other kind of rule, that is part of their thinking, it's always a part of the thinking and has influenced that. They all know about that. So I think it's a good phenomenon, it's happening, a good trend that's happening. But it's not the only answer, because you still have to deal with differences of opinion, different cultures, different nationalities.

 

>> John Hartley: Any thoughts on Japan? Japan being one of the first countries to embark on quantitative easing, we've seen this whole decade of quantitative easing. I feel like the 2010's, the monetary policy response was largely embracing this unconventional form of monetary policy of buying long term bonds, trying to bring down long term bond yields.

What do you think the legacy of that has been? And do you have any particular thoughts on Japan and being in this low interest rate environment?

>> John Taylor: Yeah, and it is a very important part of the world economy. I spent several months at the bank of Japan learning how they work and talking with the policymakers, and I followed pretty closely.

I think they have a new governor coming in, and that will change things. I think it will get back to a more rules-based policy, we'll see.

>> John Hartley: Is Kuroda leaving? He's just retiring, I think, this month. I think Kuroda is exiting this month.

>> John Taylor: Yeah, they mean well, they're good people, but I think they have lost track of how to conduct monetary policy.

And Vasil becomes back a little bit. But it's different countries, different policies that are taken throughout, and so you have to put that in the right context. But I think what's important now is how do you have a global system where each central bank, assuming there's central banks in each country that are independent.

Are conducting policy in a way that's good for their economy, but it's also good for the world economy. And that's what I hope will happen in the next few years. We've made a lot of progress, we're not there yet, that's for sure. And I think that, as you say, there's disputes, some people think it's too simple.

Some people think we need to do more complicated things. What's amazing is you don't have to be that complicated, it works pretty well. That's what evidence has shown.

>> John Hartley: It's been 50 years since Bretton Woods and we've been in this flexible exchange rate regime for some time. Any thoughts on this was obviously a big debate that Friedman had with Mundell.

Friedman definitely won the flexible exchange rates fight when 50 years ago the pegs were broken. But certainly I think Mundell was able to sort of get his Euro brain child in place and having a common currency in Euro. And obviously that's been very controversial. But I'm curious what you think of the legacy of flexible exchange rates that we all have today.

 

>> John Taylor: Milton Friedman was a good friend. He was here at Stanford for quite a few years. Talked to him a lot about policy rules, that's for sure. He knew about the Taylor rule very well. We talked a lot about that, talked about the fixed money growth rule and the idea of having a flexible exchange rate that's in the tailor roll unless you somehow get together at one central bank.

So you have the same interest rate back in Europe. But there was definitely a way. How could you realize exchange rate is gonna be flexible and still have a policy rule? And I think that's the fixed money growth rules of Milton Friedman were very much that way, and so is the tail rule.

There's no exchange rate explicitly. And that was, they say, I worried a lot about that. What about the exchange rate? And it turned out to be pretty simple. In fact, inflation rate and GDP gap and interest rate is pretty close to money growth rule. And you look at the interest rate specifically, rather than let the interest rate come out of the policy, where you have a fixed money growth, fixed money growth implies interest rate.

This way the interest rate is decided and implies the money growth rate. So the idea of a rule is very, very clear. As long as I've been in economics, I think about rules for strategies for monetary policy and fiscal policy. You asked me about how I got interested.

Well, there were rules, they were more complicated, but how could you make it simpler? And then I think that was where working in Washington and understanding and getting to know the policymakers, getting to know members of Congress, getting to know the White House, and how the president was working with other people, you began to see something simpler was gonna be important to this.

It's just, you don't want to be so complicated. There's no reason for it to be so complicated.

>> John Hartley: Absolutely and absolutely, you think about it. Taylor and Taylor rule in an open economy. Mundell Fleming says, if you're gonna have monetary policy where you can change interest rates and not have a pegged interest rate permanently, you have to allow for both movement of capital flows and to have free flow and exchange rates.

I'm curious to keep back, just on a final note here. Part of your time in Washington, you were undersecretary for international affairs. Part of that was not just focusing on the developed economies in the developed world, but also on emerging economies in many other parts of the world, the developing parts of the world.

I know you spent some time helping to set up currencies in Afghanistan and Iraq in the early 2000s. I'm just curious about your thoughts on global economic growth and your thoughts on regulation institutions. I'm sure you had many great conversations with Milton Friedman. I spent a lot of my time sort of researching on things that relate to economic growth and constraints on economic growth.

I'm curious, what is your broad thinking about? Like, what is the secret sauce to economic growth in your mind?

>> John Taylor: Well, I go back to the notion that you have good economic policy as monetary policy, fiscal policy, regulatory policy, and some international aspect. That seems to me, I've written books about that.

That's the most important thing to keep in place. So monetary policy is very important, but countries are different. Maybe fixed money growth will work best for a small economy in Africa. And so you have to recognize the institutions are different. And I've always emphasized that. I think what I've seen over the very recent years and the experience with countries is that this kind of rule, where the interest rate is the main variable, that could be countries coming together in a union of some kind, like the European Central bank and the monetary union.

But the notion that there'd be some stable, understandable monetary policy is key because, think about how terrible it can be if you don't think of Zimbabwe. I carry Zimbabwe notes in my wall to show kids how bad it can be, and it can be really terrible. And we still have that problem around.

And there's other things that interfere with monetary policy, but just focus on monetary policy. There's a lot that can be done in Africa, Asia, Latin America. Latin America still has high inflation rates. What's going on? They don't need to have that. But there's still a feeling that, well, maybe high inflation is not so bad.

In fact, right now there's people saying, well, why have a 2% inflation? Why don't we have three, four? And so I don't think that's a good idea. I testified just last week in Congress emphasize that 2% is where we are globally mimic. Many countries have that. There's a sense of that causes more stability than if it is, one has four, one has ten, one has two.

And so I think try to stick with that. And there's always temptation, hey, what, 3%, 4%? We could get to that. Not a big deal, but it is a big deal. And that is a unifying theme that I hope we continue with in the future.

>> John Hartley: Well, it's fascinating, I know there's been some discussions about potentially a monetary union between Argentina and Brazil.

I don't know if that'll happen or if that's a good deal for the Brazilians. But I know that there is a good chunk of evidence that there's resurgent economic growth and maybe some evidence that there's some convergence across the developing world. And I think, and this is really just in the past two decades.

And I think it's fair to say that a lot of that, I think, is partially and thanks to monetary stability. And I think a lot of that goes back to so much of the great work that you've done over the past decades. And I know many are still fascinated by all of your work John, I want to thank you so much for joining us today John, it's been a real pleasure having you.

 

>> John Taylor: It's been great, thanks for your great questions, terrific. I enjoyed it.

>> John Hartley: Today, our guest was John Taylor, who is the Marion Robert Raymond professor of economics at Stanford University and is a senior fellow at the Hoover Institution. This is the capitalism and freedom of the 21st century podcast where we talk about economics, markets and public policy.

I'm John Hartley, your host. Thanks so much for joining us.