McCulley on Fed Policy, Inflation, and the Taylor Rule

Michael Stephens | June 13, 2014

Paul McCulley, a familiar face at Levy Institute events (he gave a keynote at our Rio conference and at last year’s Minsky Summer Seminar), is back at PIMCO and his first note is (predictably) worth a read.

His latest essay looks at Federal Reserve policy from the standpoint of what McCulley terms the Fed’s “secular victory in the long War Against Inflation” and discusses, among other things, how the Great Moderation fed into Minskyan financial instability, how we should think about the Fed’s “neutral” real policy rate, and what this means for the question of whether stocks and bonds are overvalued. Here he is on the Taylor Rule:

The “neutral” real policy rate is not secularly constant.

It evolves as a function of changing “real” economic variables – demographics, technological progress, productivity, etc. – as well as changing institutional arrangements, notably changes in the degree of regulation of banking and finance, domestically and internationally. Thus, the notion of a “fixed” center of real policy rate gravity for prudent monetary policy is an oxymoron.

Which is why, for me, it is so befuddling that the Fed, and thus the markets, still clings – even if reluctantly – to one man’s estimate of an “equilibrium” real fed funds rate, made in 1993: John Taylor, who assumed it to be 2%, which, in his own words, was because it was “close to the assumed steady state growth rate of 2.2%.”

And that assumption became embedded in his ubiquitous Taylor Rule.


… that’s the origin of the 4% number that, to this day, the FOMC prints as its “longer-term blue dot” for where the fed funds rate “should be” (if the Fed were, theoretically, pegging the meter on both of its mandates).

I’ve got to hand it to John, whom I’ve known and liked for a very long time: Twenty-one years on, and you are still hardwired into the catechism of Fed policy!

But surely, economic life has changed since 1993, about the same time that Al Gore was inventing the Internet.

I believe the FOMC’s 4% nominal longer-term blue dot – which implicitly embeds John’s 2% real rate assumption – is wrong, unless we want to say that 2014 is 1993 redux. I don’t.

Read the whole thing.


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