Minggu, 07 Januari 2018

Taylor for Fed

I might as well share with blog readers my favorite for the Fed: John Taylor.

A preface is in order though.

Monetary policy is not, right now, the flaming hot mess that characterizes so much of the Federal Government. And all the candidates are good.

The Fed's official mandate is low interest rates, low inflation, and maximum employment -- as large as monetary policy can make it. Interest, inflation, and unemployment are each lower than they have been in living memory. The stock market is high yet surprisingly quiet (low volatility).

One may question whether this is because or despite the Fed. (My view, largely despite.) One may quibble about low growth and labor force participation. One may worry about over-regulation, though Congress mandated most of it. But by the standards of the Fed's mandate, we must admit that the outcomes we see are fine. In any other branch of the Federal government, performance like this relative to mandates, together with a tradition of reappointment, would argue for Ms. Yellen's swift reappointment.

Ms. Yellen's critics, such as the Wall Street Journal editorial page, are forced to argue that she might fall short faced with future challenges. She might keep interest rates too low for too long, and let inflation pick up. (Inflation is still nowhere in sight.) She might raise interest rates too fast if the economy does start to grow more, in fear of inflation, and choke off supply side growth. (Yes, the two criticisms are inconsistent.) She might not handle the next crisis well.

Indeed. And taking the measure of people and trying to figure out how they will deal with future challenges is just what this process is supposed to be about. One can also complain that the process of monetary policy has too much discretion, too many speeches, and needs a more stable rules based approach. I have complained that the Fed is massively over-regulating finance, and this will cause a less competitive and efficient financial system in the future.

But recognize that all this is hypothetical, and there is little to complain right now about in the outcomes we tasked the Fed to achieve.

Still, let us suppose Mr. Trump decides he wants a new person at the Fed. Why John?

John is, quite simply, the top monetary economist of his generation. He understands the theory, he understands the empirical work, he deeply knows the history. He took the baton from Milton Friedman.

After it became clear that central banks could not operate by controlling the quantity of money in the 1980s, they went back to interest rate targets. But standard monetary doctrine said interest rate targets could not work. (Friedman 1968 is classic on that.) John's "rule" describes how interest rate targets can, and should work. John's work here is not high tech math, but very transparent and intuitive. And it has had enormous impact on the world of policy. Pretty much every central bank now frames its actions with reference to Taylor's rule, or its descendants such as an inflation target.

Now, usually being a great academic is not much of a recommendation for a top Washington job however. You can fill in your own list of Nobel Prize winners, justly lauded for their intellectual accomplishments, who would be disasters in any actual job.

Still, John's stature as an academic means that he understands monetary policy, the limits of our knowledge about monetary policy, amazingly well. John knows what the equations in the staff papers mean, and can push back. Nobody will bamboozle him.

More importantly, John would, in my view, be superb in the job. He also has served in Washington, has many deep connections there, and understands the practicalities of policy.

John's great contribution is the "Taylor rule." He is unfairly tarred with the ignorant calumny that he wants to tie Fed policy to a mechanical formula. If you just listen for a moment to what John says about that, you will understand why I use such harsh language to describe his critics.

John's description of how his rule would operate is that it is mostly like a "rule" you might announce to your spouse: I'll be home for dinner by 6. You both understand that if traffic is bad, if the boss has a sudden request, if there is trouble picking up the kids from school, you'll be late. But rules engender good incentives and coordinate expectations. The spouse who shops and cooks has a good idea when and what to expect, and the spouse coming home by 6 has a special reason to really work hard to fulfill the promise. He or she will be expected to provide an explanation for deviations, but reasonable deviations are part of the game.

So too monetary policy rules are largely about stabilizing expectations, and getting past this state that markets are hanging on every word uttered by the high priests. Also, given that fact, I would hardly expect John to charge in and do anything dramatic. The point of rules is not to surprise markets after all, and most implementation of Taylor rules put a big coefficient on past interest rates, meaning one moves slowly.

The process of picking a Fed chair is not about voting on the direction of interest rates. Most of the media paints it this way -- pick one or the other depending on whether you want rates up or down. The Fed chair runs a committee and a big organization. John will be good at this too.

What you don't want in a Fed chair, especially an academic, is someone who comes in with an agenda determined to push it. Milton Friedman might have made a bad Fed chair. I suspect he might have clung to monetary targets too long. Despite the rule, Taylor is not that guy.

Taylor listens. Actually, to a fault. We run a few things together at Hoover, and there are times when he should just come out and say to me "John, that's a lousy stupid idea." Instead he listens, offers a gentle thought in the other direction, and gradually guides me to figuring out for myself just what a stupid lousy idea it was.

I also experience disagreements with John. For example, he is currently in favor of a smaller base of reserves, that don't pay interest. I like lots of excess reserves. He handles disagreement like this very well. He listens, he tells me his view, we look for different assumptions underlying our different conclusions.

This flexibility will be important. One thing we know for sure is that the next crisis will challenge any intellectual framework. It will challenge even more someone who does not have an intellectual framework and can't get back to the assumptions and logic of opposing views.

As I have prognosticated many times before, monetary policy -- raising and lowering interest rates -- is likely to be a small part of what characterizes the Fed going forward. Regulation and supervision is going to be much more important. I was a bit disappointed that Ms. Yellen seems so comfortable with the current regulatory direction. John is no fan of regulation. He has worked deeply in the area, for example on reforming bankruptcy so that banks could actually be put through it. But John is no fan of the big bank's idea of deregulation either -- keep the rules in place as barriers to entry, but lower capital and liquidity standards so we can make lots of money again. The really big question is what will happen with supervision and regulation. John will be a great chair to come to a reasonable repair of the Dodd-Frank mess.

Well, that's my case for John. As I said before, it is not a case against Ms. Yellen, or any of the other people currently under consideration. They may share many of these traits. I just don't know them that well.

Disclaimer, in case it was not obvious: John's office is next to mine at Hoover, and he's a great guy. So I'm obviously horribly biased.