Evening Must-Read: Nick Rowe: Siimple Arithmetic for John Taylor’s Mistaken Legislated Rule

Nick Rowe: Some simple arithmetic for mistakes with Taylor Rules: “If you see your neighbour thinking of doing something daft…

…apparently unaware of one of the problems, you ought to speak up. Especially if it will affect you too, because you do a lot of trade with your neighbour. A fixed Taylor Rule… makes the danger of hitting the ZLB bigger than you think it is. And Taylor Rules don’t work at the ZLB…. What happens if you are wrong about the natural rate of interest, or wrong about potential output?… If actual potential output is one percentage higher than you think it is, that makes you set the nominal rate 0.5 percentage points too high, and so inflation would need to be 0.33 percentage points too low on average to have a big enough offsetting effect to cancel out your mistake…. For a normal central bank, that is a problem, but it is not a big problem…. They fix mistakes in their Taylor Rule as they go along…. That’s probably the main reason why we always observe a lagged interest rate in the equation when we estimate a central bank’s reaction function…. But if the parameter values of the Taylor Rule are fixed by law, central banks are not allowed to learn from their mistakes…. If you really really want to legislate a Taylor Rule, OK. But there’s a price you must pay, if you want to maintain the same margin of safety against hitting the ZLB. That price is a higher average rate of inflation built right into that legislated Taylor Rule. Your choice: legislated Taylor Rules; hitting the ZLB more frequently; a higher rate of inflation. Pick any two…”