Wednesday 23, March 2022
Taylor Rule Revisited
One doesn’t hear much about the Taylor Rule these days. It’s a mechanical rule for determining what the correct level of the Fed Funds Rate should be to keep inflation under control. The definition is messy but the general idea is that if the output gap is large you should drop rates and vice versa. The output gap itself can be devined from some statistics including unemployment levels.
I guess the reason you don’t hear about it much is that applying the rule now would see short term interest rates heading for 10%. Before you say “that would crash the economy so badly 1929 would seem like a walk in the park,” remember that Fed Funds went up to nearly 20% in the 70’s.
Chris Marsh’s blog goes into a lot of detail, but it seems to me that the root of the issue is that China and globalization has changed everything. With a few hundred million peasants in China desperate to enter an urban workforce, global output could go up a huge amount before production stopped going up and industry just started increasing prices. Basing policy on a data point which is unobservable (the output gap) is surely the height of stupidity.
The great Larry Summers said, in 2013:
Everybody agrees that there was a vast amount of imprudent lending going on. Almost everybody believes that wealth, as it was experienced by households, was in excess of its reality: too much easy money, too much borrowing, too much wealth. Was there a great boom? Capacity utilization wasn’t under any great pressure. Unemployment wasn’t at any remarkably low level. Inflation was entirely quiescent. So, somehow, even a great bubble wasn’t enough to produce any excess in aggregate demand.
The clear fact is that markets do not expect more than extremely mild inflation. Long-dated Treasury yields have been falling for four decades and they are still in their clear trend. A war will produce some spikes in prices, but this is not systemic inflation. Don’t sell your bonds yet!
Wrap
Equities were weak, the dollar went up a bit, oil firmed a bit, to $114.37. Generally, today was risk off but not severely so. Rates were slightly down (10Y ~2.3%) but basically back to where they were on Friday.
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