Bernanke, Taylor Rules and the Fed Funds Rate

Thanks to Fed Chairman Ben Bernanke, economists are abuzz these days about the Taylor Rule, a simple formula that uses measures of inflation and economic slack to show where the fed funds rate should be.

Mr. Bernanke spoke at length about the Taylor Rule last week in comments at the American Economic Association. Critics have used the Taylor Rule to show that monetary policy was too easy last decade. Mr. Bernanke set out to knock that idea down. In doing so, he laid out his own preferences for how the Taylor Rule should be used.

Let’s set aside for a moment whether Bernanke’s defense of monetary policy in the 2000s stands up to scrutiny. Lots of people don’t think it did, but that’s a subject for another day.

At issue today: Did Mr. Bernanke’s speech last week send a subtly hawkish signal to the markets? His charts for how the Taylor Rule should be used showed the fed funds rate being slightly positive. Macroeconomic Advisers Vice Chairman Laurence Meyer, in a note to clients this past weekend, said that hint of hawkishness has caused a mess for markets.

Our own take: Mr. Bernanke made clear that he’s wary of putting too much weight on the rule, which is very sensitive to the numbers you punch in and the assumptions you make. If anything, it probably showed policy is in the right neighborhood right now.

To understand the hubbub, you need to understand how the Taylor Rule works. The rule holds that if inflation moves below the Fed’s target, or if the economy’s actual output moves below its long-run potential output, then the Fed should reduce the interest rate by some prescribed amount. If inflation goes above the target, or actual output goes above potential output, then the Fed should raise the fed funds rate.

(Bernanke gives a very lucid explanation of how it works in his speech, which is worth reading if you want to learn more about the mechanics of the rule.)

There are several problems with the Taylor Rule, which Bernanke lays out to show why it wasn’t a good guidepost last decade.

One problem is that it is very sensitive to the numbers that you plug in for inflation and for the deviation of output from its potential (which is known as the output gap.) Mr. Bernanke prefers to use forecasts for inflation. Mr. Taylor uses actual inflation measures. You can get much different results depending on which numbers you use. (Right now, using forecasts rather than real-time data yields a slightly higher fed funds rate because the output gap is projected to narrow in the months ahead as economic growth resumes.)

The formula is also especially sensitive to how much weight you give the output gap and inflation. If you give extra weight to the output gap, something Mr. Meyer and others prefer to do, you can get a much lower fed funds rate.

The charts in Mr. Bernanke’s speech (table 4) showed his preferred Taylor rule spitting out a slightly positive fed funds rate. You might infer some hawkishness in that. But in fact the fed funds rate is slightly positive right now, with the Fed’s target for the rate between zero and .25 percent.

We plugged in our own numbers to a spreadsheet using a an average of the Federal Open Market Committee’s own forecast for inflation (1.45% for 2010), the Congressional Budget Office’s forecast for the output gap (a 5.5% shortfall of output from the economy’s potential) and Mr. Taylor’s original 0.5 weightings for inflation and the output gap in his formula. That spits out a 0.55% fed funds rate. Tweak the weightings a little bit, and the fed funds rate quickly goes negative. The sensitivity shows why Fed officials are wary of relying too much on the rule.

As an aside, what we found most striking about this exercise was the grim outlook for the output gap. If the CBO is right about the outlook for economic growth and for the economy’s potential output, then the economy is going to be operating below its potential for most of the rest of the decade. That’s bad news for unemployment and for the budget outlook.