Ben Bernanke's Big Problem

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Ben Bernanke has proved that he’s an effective public advocate for the Federal Reserve, ably defending it in front of his Capitol Hill inquisitors. One of his most effect talking points was to argue that the Fed has an effective “tool kit” to implement on “exit strategy” to prevent hyperinflation once the economy starts to recover.

Unfortunately, Bernanke lacks the one tool he needs the most: a gauge to tell him when to use the other monetary policy tools.

Without a functioning gauge, the other tools are useless. Or perhaps outright dangerous. The ship of monetary policy is sailing at full mast without a compass.

Take the oft-cited Taylor Rule. That’s a rule developed by John Taylor, a Stanford University economist, that supposedly tells central bankers the correct rate of interest, the one that will spur growth without sparking inflation.  On its face, it is actually rather simple. It says that the Fed’s  main target interest rate should be 1.5 times the inflation rate, plus 0.5 times the gap between the economy’s potential growth rate and the current pace, plus 1.

Taylor himself thinks that right now the Fed policy is just about right. His calculations show that the rate should be just a little under negative one per cent. Since the Fed can’t really charge negative interest rates, it has to use creative “quantitative easing” to push rates down to the appropriate levels. Which is what it’s been doing.

But other economists say that Taylor is under-estimating how far down the rates need to go. They think that their version of thee Taylor Rule indicates the Fed needs to push rates all the way down to negative 5 per cent. 

Goldman Sachs economist Jan Hatzius wrote in a note that “the difference is fully explained by two choices.”

First, Taylor uses his “original” rule with an assumed (but not econometrically estimated) coefficient of 0.5 on both the output gap and the inflation gap, while the Fed uses an estimated rule with a bigger coefficient on the output gap. Second, Taylor uses current values for both gaps, while the Fed’s estimate of a -5% rate refers to a projection for the end of 2009, assuming a further rise in the output gap and a decline in core inflation.

Well, we’re glad that fully explains things. You’re totally comfortable, right? Output gap, inflation gap, coefficents, declines in core inflation. Relying on all that is totally reasonable fully explains everything.

Except it doesn’t. What’s going on here is mathematically gifted people attempting to render a non-mathematical process into a formula. To put it differently, they are pretending the economy is far more legible than it really is.  The very existence of this dispute between Taylor and his critics over the Taylor Rule is evidence that there’s no genuine compass for monetary policy available to Bernanke.

The truth is that inflation can get going way before it shows up in the CPI, which means that whichever version of the Taylor Rule you use can easily lead you astray. Money doesn’t enter the economy evenly, and once it has entered it doesn’t distribute evenly. It often clusters or bubbles in one spot or another. That’s one of the lessons we would have hoped everyone had learned from the great catastrophe we’re still muddling through.

But, instead, these guys keep fretting over how to plot a course on a map, assuming their map matches the territory, when they really have no idea where on the map they are.

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