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A public policy blog from AEI
The most prominent piece of legislation, sponsored by Reps. Bill Huizenga, R-Mich., and Scott Garrett, R-N.J., is a result of a yearlong series of hearings orchestrated by Hensarling’s committee. It would require the Fed to set interest rates based on something like the Taylor Rule, a formula written by Stanford economist John Taylor, which specifies the appropriate level of interest rates based on the pace of inflation and the gap between actual and potential economic output. The Fed would be required to explain deviations from its rule, although it could change the rule. It would also be subject to audits by the Government Accountability Office.
Would the Taylor Rule be the proper rule for the Fed? Economist Paul Dales of Capital Economics outlines his doubts (as well as nicely explaining the Taylor Rule):
John Taylor’s original rule stated that the nominal interest rate should equal the neutral real interest rate (set at 2%) plus inflation, plus the gap between inflation and a target rate (again set to 2%), plus the output gap. Both the inflation and output gap terms are given equal weightings of +0.5, meaning that if the inflation gap and/or the output gap are positive, the actual interest rate should be above the neutral rate. In the long-run, Taylor’s rule assumes that the nominal neutral interest rate is 4%. Using that rule, the Fed should have started raising interest rates in early 2012.
There are two reasons, however, why the Fed has not followed this rule. First, the rule assumes that the neutral real rate is 2% when most evidence suggests it is now lower. The Fed believes that the neutral real rate will rebound to 1.75% in the long-run, but suspects it will remain substantially lower for some time. Our analysis suggests that, due to the fall in the economy’s potential growth rate, the higher cost of financial intermediation, increased risk aversion and higher precautionary saving, it will remain closer to 1.0%.
Second, Taylor’s rule does not take into account the possibility that there is more slack than the unemployment rate and most output gap measures suggest. We’re not convinced by this, but it is a big part of the Fed’s thinking. In light of the declining participation rate, the Fed could even stop responding to the falling unemployment rate altogether and instead focus on the employment-to-population ratio.
Since employment-to-population ratio remains well below its historical trend, it indicates that there is still plenty of slack in the labour market. An alternative policy rule that includes the employment-to-population ratio implies that the first interest rate hike won’t come until 2017.
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