Emi Nakamura on Central Bank Credibility and the Taylor Rule

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1:51Hello and welcome to another episode of the All Thoughts Podcast. I'm Tracy Alloway. And I'm Joe Weisenthal. Joe, we're back in Jackson Hole. Jackson Hole. I love it here. It's beautiful. It's beautiful. And not only do we get a chance to enjoy the gorgeous scenery, we get a chance to talk economic policy. There's so much going on right now, to say the least. We don't need to recapitulate. Everyone knows what's going on right now. There's so much stuff, whether we're talking about macro situation, whether we're talking about whatever. I love how you say there's no need to recapitulate, and then you immediately do it.

2:21But you know, there's just so much going on. I think you're hitting on a couple of things, which is there are these different themes floating through the conference. So obviously you have uncertainty over what tariffs actually do to the economy. What type of shock are they? Do they destroy demand and therefore maybe cause deflation? Or do they lead to companies passing on those costs and cause inflation? There's central bank independence, which everyone wants to talk about. And there's obviously the direction of short-term interest rates. And then, of course, the formal theme of the conference about labor markets and all this stuff.

2:55So yes, many different things going on. All right. Well, I am very pleased to say that there is, in fact, one paper that ties basically all these themes together. So we have the author here and really the perfect guest to talk. Someone we've wanted to talk to for a long time. Absolutely. We're going to be speaking with Emi Nakamura, a professor at Berkeley and the author of a paper being presented at Jackson Hole called Beyond the Taylor Rule. So, Emmy, thank you so much for coming on All Thoughts. It's great to be here. Let's just start. What is the Taylor Rule? Before we can go beyond it. Yeah, yeah.

3:28Well, in 1993, John Taylor wrote a paper in which he showed that the behavior of the Federal Reserve could be described by this remarkably simple rule as a function of inflation and what people call the output gap, which is sort of a measure of how overheated the economy is. And this was very surprising to people because people typically think of what the Federal Reserve and other central banks do as incredibly complicated. And so the surprise was that you could actually describe it by something very simple. And since that time, when John Taylor wrote his original paper in 1993, the Taylor rule has achieved more or less mythical status within economics and the policymaking world.

4:06The original paper was mostly descriptive. Like I said, it was pointing out that the behavior of the Fed, which seemed complicated, could actually be described by something really simple. But since then, it's really become a guide for prescriptive monetary policy. And when central banks deviate from the Taylor Rule, they're often asked to explain why this was a major theme in the post-COVID inflation, for example. So on that note, could I ask why the Taylor Rule specifically? And talk to us maybe about the process of how these papers come into being ahead of Jackson Hole. Why we wrote about the Taylor Rule.

4:42Well, as I said, the Taylor Rule has achieved this incredibly dominant status within not only the academic literature on monetary policy, but also within the policy community. And yet, when I teach students, one of the things that's somewhat uncomfortable is that the Taylor Rule doesn't fit all that well over the past 20 years. So it fit pretty well during the Greenspan period and all the way until about 2008 in the United States. But it hasn't fit very well since then. First of all, there was the zero lower bound period when interest rates were just at zero. But it also didn't predict very well either the timing or the magnitude of the liftoff from zero interest rates.

5:21So given that 20 years is starting to be a long time, the question is should we still view this as the benchmark for describing monetary policy? And then there's the second question about how to think about good monetary policy. So when John Taylor wrote his original paper, you know, it was mostly descriptive paper, but he did point out that this was a time period. The time period he said was actually only six years. It was from 1987 to 1992. But he pointed out that this was a time period a lot of people thought of as representing good monetary policy. So while the paper was mostly descriptive, he did say, you know, well, maybe this is a guide to good monetary policy too.

5:56And that's a theme that a lot of people have picked up on since then. And we thought it was important to sort of reinvestigate that theme. But this is funny, right? Because there is this tension of whether it's a descriptive or prescriptive thing. And I've heard for years people on TV, it's like, oh, the Taylor rule says it should be a lot higher or the Taylor rule says it should be lower or whatever. But we just heard it from Jeff Schmidt at the Kansas Fed, right? And yet this is all based on basically a sort of backing out description of five years of monetary policy. Six years. Six years. OK, sorry.

6:26Six years. Maybe it's not quite so. Can you talk a little bit more about, though, this, I don't know if it's a debate or how people think about prescriptive versus descriptive within this role? So the tension that you're describing is exactly what motivated us to write this paper, because it's interesting how a framework like this, which is so simple and so powerful in terms of describing monetary policy, and does say some things that are very true about what monetary policy should do in terms of leaning against inflation, leaning against an overheating economy can end up becoming maybe more than even the author intended as a prescriptive rule.

7:05And one of the things that we want to remind people of is the historical context for when John Taylor's paper was written. So it was written in 1993. This was a period when the Fed was coming off some very difficult years for monetary policy. So the 1970s and 1980s were very difficult years for monetary policy. Inflation had been very high in the late 1970s and early 1980s. the Fed's reputation was, to say the least, limited as an inflation fighter. Inflation expectations were not nearly as anchored as they are today. So it was a very different time. And I think some of the context for John Taylor's paper is saying that when you have those kinds of reputational challenges, sometimes you kind of need to tie yourself to a mask and say, we are not going to - Just go by a mathematical rule.

7:53Exactly. Because the 1970s are also one of the time periods in history which is best known for political pressure on the Fed. And so in the context of that kind of political pressure, one of the things you want to think about doing is giving people a very simple observable metric for how you adjust interest rates. But then, of course, by several decades later, the Fed's reputation had changed pretty dramatically. We had seen decades of low and stable inflation. And, you know, the Fed and other central banks around the world had really developed a very strong inflation-fighting reputation. And so then the question arises, is the same kind of tying-your-hands approach appropriate, even in the context of, you know, shocks like what we saw after COVID?

8:41And so this is the sense in which I think, you know, this is a time at which we want to ask these questions. It reminds me very much of the SOM rule and the arguments there that if you find like a specific number, the idea is that you use a sort of simple formula and then you immediately jump into action. So on that note, one of the key things about the Taylor rule is that it suggests rates need to rise by more than one for one with inflation to properly offset inflation. Like you have to go in very, very strong. But you found in your paper that that's not always the case. Exactly. So even beyond the idea that you want to raise interest rates more than one for one, so it's the coefficient of 1.5 in the Taylor rule, but there's the idea even beyond that of the Taylor principle, which is exactly what you described, that you want to not only raise interest rates, nominal interest rates with inflation, but you want to raise real interest rates.

9:33then you have to raise nominal interest rates more than one for one, exactly what you said. And so that's kind of a core idea. And it's one of the main reasons why the gap between the Taylor rule prescription and what central banks actually did during the COVID inflation was so large. And actually for the United States, this gap was over 10 percentage points. So we are talking about a very large gap. And the COVID inflation saw the largest gap in history. So why does that not actually happen always in monetary theory? Well, the reason is because there are different sources of inflation. So the motivation for leading hard against inflation that is probably pretty intuitive to most people is demand-driven inflation.

10:12So when inflation is coming from an overheating economy, then there's this notion in monetary economics that you can satisfy all objectives of both kind of calming down the economy, but also keeping inflation in check by raising interest rates pretty aggressively. And actually, optimal monetary policy theory implies you might even want to be more aggressive than the Taylor rule. But in contrast, when you have shocks to inflation that don't come directly from an overheating economy, but also come from other sources of increases in costs, so the supply shocks that people talked about during the COVID inflation period, then these same models can imply very different predictions.

10:48They can imply that you don't want to raise interest rates nearly so much in response to inflation associated with these kinds of shocks. So in our paper, what we do is we use a very standard monetary model, and we simulate data from this model where we assume that the monetary policy is actually exactly optimal. So the central bank is really doing the right thing. And then we run regressions, you know, where we try to estimate what would you get for the Taylor rule in this context. And then the interesting observation is that you find that actually a lot of times the coefficient on inflation is less than one.

11:21Sometimes it's close to zero, sometimes it's even negative. So really, a lot of things can happen when you deviate only from this view of inflation is coming from an overheating economy.

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13:13That's H-I-S-C-O-X dot com. There's no business like small business, Hiscock's Small Business Insurance. Did the Fed do a good job? The paper reads like vindication. Yeah, because I think in 2025, there's still plenty of fights about this question. What's your take? I think in, so we don't know what's going to happen. Yeah, of course, going forward. But I think in the long span of history, if you look at what happened over the past five years, I think this is going to look like a soft landing. And that is typically exactly what the Federal Reserve is trying to achieve. So, I mean, obviously, the Fed appropriately and private sector forecasters took a lot of flack for saying that inflation was going to be very transitory when inflation was significantly more persistent.

13:58That said, inflation did come down very quickly. And there hasn't been a recession. And that is remarkable. And not only has there not been a recession, and not only did inflation come down very quickly, but longer term inflation expectations really did not become unhinged despite this historic increase in inflation. We haven't seen large increases in longer term bond yields. So this is all pretty remarkable. And I would think that if things go well over the next five years, that in the longer span of history, this is going to look like a big success. So this is where central bank independence and credibility actually comes into play when it comes to those longer-term inflation expectations.

14:41How did you actually measure credibility in this paper? Because you don't look just at the Fed. You look at a bunch of other central banks. Right. So when we look at other central banks, one of the things we point out is that there was a huge amount of variation in terms of how different central banks reacted to the COVID inflation. So we've been talking about the United States and similarly countries like Japan, the UK, the euro area. these countries all raised interest rates very gradually and by very moderate amounts relative to the size of the inflation increases they were facing. And so they all took a lot of flack for raising interest rates too slowly, for being behind the curve, for not raising interest rates enough.

15:21And these are the countries we refer to in our paper as late risers because they were a little late to the game, right? But there were other countries in the world that we refer to as early risers who raised interest rates a lot more aggressively and a lot earlier. And the interesting observation, you might have thought that these countries would have suffered from the fact, the late riser countries would have suffered from the fact that they were late to the game in raising interest rates with having higher inflation than the early risers who responded very aggressively. And in fact, we find the opposite.

15:53So the early risers did respond very aggressively to the COVID inflation, but they actually saw inflation rise by a lot more during this episode. So then we asked the question, well, what could explain that? That seems sort of backwards. You know, you have these countries that seem to have responded very aggressively with interest rates, and yet they saw the larger and more persistent inflationary surges. But then what we see is that those same countries are countries that have much more checkered inflation histories. So you asked about reputation. Well, a very simple way to ask about the reputation of a central bank for controlling inflation is just to look at average inflation in the recent decades.

16:30And so we look at average inflation over the previous three decades, and we see that the early riser countries, the ones that probably felt they had to respond very aggressively to the COVID inflation, also had much more checkered inflation histories. They had much higher average inflation over the past three decades previous to COVID. And so I think a natural interpretation of these facts is that for these countries, They did not feel that they had the inflation-fighting credibility of the central banks in the United States or in Japan or in the Euro area. They did not feel that they had the kind of strongly anchored inflation expectations that these countries could benefit from.

17:10And so for these countries, it really probably was not an option to think that they could look through, you know, the inflation and yet keep inflation expectations anchored. But yet that is actually what happened in the United States and several other of these late riser countries. So I find this to be really fascinating. And I want to get to the question of whether the developed market or the U.S. has ground down its stock of credibility over the last five years. But on this question of the early risers, I get what you're saying. But it's still not intuitive to me that the countries or the central banks with a sort of mediocre history of controlling inflation this time around were really on the ball in unison.

17:52I mean, I would think that if a central bank has a history of missing its inflation target or letting inflation rise, that at least some of them would have done it again. They would have come in late because that's what they do institutionally. How consistent is this process around the world, whereby the countries that have a bad track record were early risers this time around. Right. So we're not including every country. So there are some countries which are outliers in terms of their response, in terms of their inflation. But I think one of the things you have to recognize is that in the world as a whole, there has been quite a remarkable sort of triumph of central banks over inflation.

18:30So back in the 1970s and 1980s, almost every country was like what we see in the early risers today. So none of these countries had really strong credentials as inflation fighters. And more recently, there are a number of these countries which are kind of moving in the direction of having much stronger inflation fighting credentials. But at the same time, you know, these are countries where it's a relatively fresh history, you know, so you look at some of these countries where they had pretty high inflation in the past. And, you know, and they're just sort of starting to be able to get over it.

19:03And then the question is, do you think that the public will be willing to watch you go through a period of, say, 10 % inflation and say, oh, we're sure you're going to get it back to 2 %? Or do you think there's going to be a real question of whether you're going to be able to achieve that? Okay. So if, on the other hand, you do have good credibility, you do have a good history of inflation fighting, then you can kind of spend that social capital, I guess, and avoid having to raise interest rates by as much as maybe another central bank that doesn't have that credibility. Walk us through what exactly are the benefits of not having to do that?

19:41Of not having to raise rates. Early rise. Absolutely. Well, you get closer to optimal monetary policy. So in the models, the basic idea is, for example, if you have one of these cost push shocks where there's a shock that is going directly to inflation because of increases in costs or bottlenecks of various types, or you have a shock like during COVID to people's demand for goods versus services, if you raise the interest rate dramatically, like the Taylor rule might have predicted, you raise the interest rate to 10%. So what's going to have to happen to get inflation down to zero in the short run?

20:14Well, maybe you're going to have to have a big recession. You're going to have to have one part of the economy completely collapse. Trump will tweet at you more or post on Truth Social more. Probably. You're going to have to have really negative inflation in some sectors of the economy, and you're going to have to have a big recession. And potentially, you know, the other issue is that there's a lot of evidence suggesting that monetary policy has pretty delayed effects. So another concern, and as I said, you know, in this episode, professional forecasters and the Fed both thought that the inflation would be more transitory than it actually was.

20:46But another concern is if you think that the shocks that are causing the inflation are sort of going to dissipate on their own, and you think that monetary policy is going it takes some time to have an effect, then one of the concerns is that by the time the monetary policy actually has a large effect, then some of these shocks are going to dissipate. And then I guess the third thing I would mention is that in theory, the central bank actually wants to use a combination not only of current interest rate movements, but also of forward guidance. So this is one of the big innovations in monetary policy over recent decades.

21:22We think about forward guidance a lot in the context of the zero lower bound when you can't do anything with, you know, Fed funds rate. And so it's all about forward guidance. But actually, forward guidance is a much, much more general phenomenon. It's really whenever the central bank is calling its shots about what it's going to do with interest rates even over the next year. So this was hugely important during the COVID inflationary surge because the Fed started talking about raising interest rates and longer term bond yields started rising pretty rapidly in late 2021, substantially before the Fed funds rate actually started to rise rapidly.

21:58And in the theory, a central bank that has that power, it has the ability to affect the economy, not just through what it does with the Fed funds rate, but also through its words and impact on the bond market through that channel will actually want to use both. And so that's another advantage of not being bound by these kinds of constraints. This strikes me as an incredibly important point, which is that you can tighten monetary policy by talking about it. By saying stuff. And so that just by looking at that overnight rate that the rule might anticipate, et cetera, does not necessarily capture the stance of monetary at that time if you already indicated and you're pulling forward those rate hikes.

22:37So do we have less credibility today? So, OK, maybe the Fed did a good job in this time. Nonetheless, there was this very big inflationary episode, et cetera. So after years of very cool inflation, finally, we got a big one. going forward, does that mean the next time around, if there is another inflationary shock, for whatever reason, that the Fed might be impelled to be more of an early riser than it felt in this cycle? I would think almost definitely yes. Remember that going into the COVID inflation, regular people hadn't seen significant amounts of inflation for years. It just wasn't really part of the mindset of anyone.

23:18You know, when you saw, for example, unions in wage negotiations or other contexts, things where inflation should have been relevant, it was sort of striking that it just wasn't on anyone's mind. And it even took a while after the inflation started for people to even think about this, because it had become so much of a non-issue for so many years that it was just not part of the mental frame of Americans. I see this very much when I teach students because for American students, typically, I have to do a lot of work to just explain the difference, for example, between a nominal interest rate and a real interest rate.

23:50I did not earn interest on my bank account for most of my adult life. So I sympathize. Exactly. But in contrast, for Latin American students, they get it immediately because it's just part of how they grew up, right? And I think that that distinction has probably blurred at least a little bit, right? Because now people have gone through a few years where it mattered to pay a little bit of attention to inflation. And so my guess is that if we start to see inflation again, it's going to be a much more rapid transition to where people will start to ask whether this is going to last longer, whether now that we've seen two inflationary episodes in the recent past, whether this is sort of the new normal.

24:31You know, I think it's important not to forget how hard won those expectations of low inflation were for the Federal Reserve and many other countries. You know, it's certainly something that can dissipate. So because we're dealing with the Taylor Rule, which basically, you know, suggests or describes either way what the central bank should do with interest rates in response to inflation and changes in the output gap, we're talking basically about like the impact of shocks to that output gap. There's a nuance here because like shocks can be different and have different effects on the output gap.