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European
Economic Perspectives 25
Taylor
Rules, OK?
The
Perils of Active Monetary Policy
Since
John Taylor’s seminal 1993 paper describing the Federal Reserve’s
monetary policy, a large body of economic research has argued that
active interest rate feedback rules contribute to macroeconomic
stability. But are these ‘Taylor rules’ – which stipulate that the
response to increases or decreases in inflation is a more than
one-for-one increase or decrease in the nominal interest rate – really
stabilizing? A recent CEPR
Discussion Paper by
Jess Benhabib, Stephanie Schmitt-Grohé and Martin Uribe – ‘The
Perils of Taylor Rules’, No. 2314 (December 1999) – expresses
serious doubts.
Benhabib
et al argue that analysing active monetary policy rules in theoretical
models generally reveals indeterminacy and multiple equilibria. Pursuing
such a policy can easily lead to unexpected consequences even in the
simplest and most innocuous monetary models, using the simplest and most
standard assumptions. The reason the researchers arrive at such a
different conclusion from much of the existing literature is not that
they use a different theoretical framework but that they explicitly take
account of the fact that nominal interest rates cannot fall below zero.
It
immediately follows from this observation that a central bank cannot
have a globally active policy stance. For inflation rates sufficiently
below the inflation target, the central bank runs into the zero bound on
nominal rates and can no longer pursue an active monetary policy. In
other words, it can no longer respond to decreases in the inflation rate
by cutting short-term interest rates by even more. As a result, the
economy can become trapped in a low-inflation, low-output equilibrium
and expectations of low or even deflationary equilibria become
self-fulfilling. Such liquidity traps arise because the central bank
cannot credibly threaten to create inflation by lowering rates in an
environment with near zero nominal rates.
Previous
researchers have limited their analysis to the impact of interest rate
feedback rules on stability under scenarios in which inflation remains
forever near the central bank’s long-run inflation target. One
justification for such a strategy is the implicit assumption that all
inflation paths that move far enough away from the inflation target are
explosive and thus cannot be supported as equilibrium outcomes.
But
according to this research, the zero bound on nominal rates implies that
paths for the inflation rate in which inflation moves further and
further below its target do not become explosive and can indeed be
supported as equilibrium outcomes. Both theoretical models and
simulations of calibrated economies suggest that active interest rate
feedback rules can give rise to self-fulfilling liquidity traps in the
context of models where prices are either flexible or ‘sticky’.
The
researchers also find that there are equilibria in which the economy
converges on the liquidity trap with positive probability but the
inflation rate fluctuates for long periods of time around the target
rate and monetary policy is, thus, active. It follows that an
econometrician using data generated from an economy of this type to
estimate the interest rate feedback rule may very well conclude that the
economy is displaying stationary fluctuations around the target rate,
even though the economy is in fact spiralling down into a liquidity
trap.
These
results suggest that central banks that maintain an active monetary
policy stance near a given inflation target are more likely to lead the
economy into a deflationary spiral – like the one currently observed
in Japan and, some might argue, in Europe – than central banks that
maintain a globally passive monetary stance, such as an interest-rate or
exchange-rate peg.
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