The Race to Subzero: John B. Taylor et al. on Monetary Policy in the 21st Century
“We’d all be better off globally if interest rates went back into positive territory, ” John B. Taylor said in an interview with The Politic. Taylor, the Mary and Robert Raymond Professor of Economics at Stanford University, served as Undersecretary of International Affairs at the U.S. Treasury from 2001 to 2005. But he is best known as the mastermind behind the eponymous “Taylor rule,” a simple but powerful rule of thumb for monetary policymakers.
Taylor’s rule prescribes an equation for a central bank’s policy interest rate, which determines the rates at which banks borrow and lend. It does so based on the level of inflation and output growth. Under Taylor’s prescription, central banks set higher rates to contract lending and investment as inflation and output growth rise—that is, as the economy runs hot. Conversely, the rule calls for a lowering of rates to stimulate the economy when inflation and output growth are low.
Although the rule wasn’t formally introduced until 1992, the Federal Reserve more or less set a policy interest rate close to the precise rate the Taylor rule would prescribe starting in the early 1980s and continuing into the early 2000s. This period of rule-based monetary policymaking is now known as the “Great Moderation” and was marked by robust economic growth, low inflation and unemployment, and shallow recessions.
However, monetary policy in the U.S. and abroad lost sight of the policy rule in the years leading up to the global financial crisis of 2008-09. Interest rates were set far lower than those called for by the rule, fueling a credit boom that led to the housing bubble. And although rates briefly recalibrated following the Great Recession, a majority have once again deviated downward in recent years, some even turning negative. Taylor and researchers at the Bank of International Settlements, the central bank for central bankers, term this phenomenon the “Global Great Deviation.”
According to Taylor, the deviation in global rates is largely a result of concern around exchange rate effects of monetary policymaking. If a large foreign central bank slashes its policy rate in a bid to bolster growth and inflation, for instance, the home currency appreciates relative to the foreign. This dilutes the value of domestic exports—that is, unless the home central bank follows suit in cutting its interest rate to offset the appreciation. The reverse is true if a foreign central bank raises its rate; however, because central banks are more worried about exchange rate appreciation than depreciation, rates are biased downwards. Central banks around the world, therefore, have begun to follow one another in setting lower and lower policy rates, with several drifting into negative territory, as they defend against a stronger home currency.
There is considerable evidence to support Taylor’s theory of competitive devaluation. The central bank of Norway, for example, transparently admits that it adjusts its policy rate in tandem with that set by the European Central Bank (ECB) to protect against a stronger Norwegian krone. While other central banks tend to be less forthcoming, anecdotal evidence supports the notion that policy rate spillover is motivated by exchange rate concerns. On one occasion, Taylor asked Mervyn King, former governor of the Bank of England, why he had lowered rates just as the U.S. had. “I can’t have the pound appreciate,” King responded candidly.
In his latest book, Taylor warns against such increasingly correlated and interconnected international monetary policy. He claims that the current paradigm of discretionary monetary policy has led global interest rates astray, in a race to subzero. As of March 2020, the benchmark interest rates in Switzerland, Denmark, Japan, and the Eurozone are below zero.
Some economists disagree with Taylor’s analysis, alleging he is overly wedded to his particular rule.
Bill English, a professor in the practice of finance at Yale University, is among Taylor’s critics. English is less convinced that competitive devaluation is such a problem, at least among advanced economies. He believes that central banks should care about the exchange rate insofar as it has implications for maximum employment and price stability—the two goals of central banks. Lower and lower rates, he explains, are simply a response to high unemployment and low inflation, which may, in part, be caused by a strong currency.
Robert Shiller, a Nobel Prize-winning economist and Sterling Professor at Yale, tends to agree with English. “Maybe it’s a good outcome,” Shiller told The Politic, “that all the European central banks have low or negative interest rates given the weakness of their economies.”
However, the problem with negative and “low-for-long” interest rates is twofold. First, lower and lower rates threaten financial stability through effects on banks, insurance companies, and pension funds. Bank profitability contracts as the net interest margin—the difference between the loan and deposit rate—is squeezed because the rate on loans decreases while the rate on deposits is stuck near zero. Insurance company and pension fund solvency is threatened as lower rates raise the value of their long-term liabilities more than that of their short-term assets. Second, there are limits to how low rates can go—and therefore how much they can accomplish. Why lose money on a bank deposit when holding cash is a better alternative?
This imbalance between the costs and benefits of negative rates is substantial. Negative rates have failed at what they were meant to accomplish—bolstering inflation and real GDP growth—while bringing about a slew of financial complications.
Janet Yellen, former Chair of the Federal Reserve, like Taylor, questions the merits of negative rates. “[Setting rates negative] provides only a small degree of additional policy flexibility,” she said in an interview with The Politic, “and it could have an extremely negative effect on banks, really depressing their income.” In fact, she thinks such pressure on banks might actually lead to a drying up of credit and a contraction in lending. For these reasons, Yellen explains that there has always been “a real lack of enthusiasm” for negative rates in the United States.
Across the pond, however, the ECB hasn’t been afraid to deploy subzero rates and reaffirmed its commitment to negative rate policy in January. The ECB hopes that leaving rates negative for the foreseeable future will bolster persistently low inflation “robustly” back to the target of just under two percent.
Some argue that central banks like the ECB have become overly focused on inflation targets. “The greater attention to a numerical inflation target,” Taylor claims, “may have reduced attention to other aspects of the policy rules, including the idea that we need a policy rule at all.” Perhaps central banks ought to replace a target point with a target range. Precision around an inflation target results in less precision of other parameters, including the magnitude of the monetary policy response. This may lead central banks to pernicious discretionary policy decisions, such as that of introducing negative rates.
To avoid such outcomes, Taylor advocates for a rule-based reform of the international monetary system, with central banks around the world each formulating a policy rule and sticking to it. Because household and firm decisions depend on expectations of the future, such consistency would further help them better anticipate the actions of monetary policymakers.
Ben Bernanke, former Chair of the Federal Reserve, has historically disagreed with Taylor, claiming that while the Taylor rule is a good descriptive instrument, it is far too simplistic to be a prescriptive tool. He argues that monetary policy should be systematic, not automatic.
But Taylor is woefully misunderstood. He isn’t advocating for the policy rule to supplant the central banker. Instead, the rule is meant simply to guide the Federal Reserve’s decisions—preventing erratic policy choices motivated by political interests or international considerations—and ensure accountability. Both Taylor and Bernanke are for systematic monetary policy, although the former holds a more rigid conception of a systematic policy framework with less room for deviation from a rule.
While there is little agreement on the matter of negative rate policy, it appears there is some consensus surrounding the idea of systematic monetary policy. Janet Yellen and Bill English—who served as Secretary of the Federal Open Markets Committee of the Federal Reserve under Yellen—share at least some of Taylor’s enthusiasm for rule-based monetary policymaking.
Both English and Yellen worry, though, about having just one rule. “It’s really a communication problem,” English told The Politic. “If you had one rule and pointed to it,” he claims, “it would become very difficult to deviate from it.” Yellen similarly said she was “not in favor of tying the hands of [central banks] to one policy rule.” She added, “I am however in favor of the Fed carefully explaining what it is doing and why as well as behaving in a systematic fashion.”
Starting with Yellen’s term, the Federal Reserve has begun to, in its Monetary Policy Report, place its policy interest rate within the range of rates prescribed by various policy rules. Any one rule may be ill-suited or outdated, but the prescriptions of several different rules are likely to establish a healthy range. Although there may be disagreement as to where within this broad range optimal policy lies, it is helpful in guiding monetary policy and keeping it from veering off course. Perhaps the U.S. ought to export such a systematic approach abroad, to Europe and Japan, where unchecked discretion appears to have prompted a race to subzero.