WEBVTT - Emi Nakamura on Central Bank Credibility and the Taylor Rule 0:00:02.480 --> 0:00:15.800 Bloomberg Audio Studios, Podcasts, Radio News. 0:00:18.079 --> 0:00:21.000 Hello and welcome to another episode of the Authoughts podcast. 0:00:21.120 --> 0:00:22.440 I'm Tracy Alloway. 0:00:22.200 --> 0:00:23.759 And I'm Joe. Why isn't thal Joe? 0:00:23.760 --> 0:00:25.360 We're back in Jackson Hall. 0:00:25.280 --> 0:00:26.320 Jackson Hall. I love it here. 0:00:26.480 --> 0:00:29.760 It's beautiful. It's beautiful, And not only do we get 0:00:29.760 --> 0:00:32.640 a chance to enjoy the gorgeous scenery, we get a 0:00:32.760 --> 0:00:34.440 chance to talk economic policy. 0:00:34.560 --> 0:00:37.720 There's so much going on right now. To see the least, 0:00:37.720 --> 0:00:39.839 we don't need to recapituate. Everyone knows what's going on 0:00:39.920 --> 0:00:41.880 right now. There's so much stuff, whether we're talking about 0:00:42.440 --> 0:00:44.720 macro situation, whether we're talking about whatever. 0:00:44.800 --> 0:00:46.920 I love how you say there's no need to recapitulate 0:00:46.920 --> 0:00:48.000 and then you immediately do it. 0:00:48.240 --> 0:00:49.320 Well, there's just so much going on. 0:00:49.520 --> 0:00:51.880 I think you're hitting on like a couple things. Which 0:00:51.920 --> 0:00:54.920 is there are these different themes floating through the conference, 0:00:54.920 --> 0:00:57.920 So obviously you have uncertainty over what tariffs actually do 0:00:58.040 --> 0:01:00.560 to the economy, like what type of shock are they? 0:01:00.840 --> 0:01:04.840 Do they destroy demand and therefore maybe cause deflation, or 0:01:04.920 --> 0:01:07.320 do they lead to companies passing on those costs and 0:01:07.360 --> 0:01:11.280 cause inflation. There's central bank independence, which everyone wants to 0:01:11.280 --> 0:01:14.240 talk about. And there's obviously the direction of short term 0:01:14.280 --> 0:01:15.640 interest rates. 0:01:15.480 --> 0:01:17.839 And then of course the formal and then of course 0:01:17.880 --> 0:01:20.839 the formal theme of the conference about labor, labor markets 0:01:20.840 --> 0:01:23.120 and all this stuff. So yes, many different things. 0:01:22.880 --> 0:01:25.280 Going on, all right, Well, I am very pleased to 0:01:25.280 --> 0:01:28.880 say that there is in fact one paper that ties 0:01:29.000 --> 0:01:32.839 basically all these themes together. So we have the author 0:01:32.880 --> 0:01:35.560 here and really the perfect guest to Jehan. 0:01:35.400 --> 0:01:36.840 We've wanted to talk to for a long time. 0:01:37.000 --> 0:01:40.039 Absolutely, we're going to be speaking with Emmy Nakamura, a 0:01:40.200 --> 0:01:43.240 professor at Berkeley and the author of a paper being 0:01:43.280 --> 0:01:47.480 presented at Jackson Hole called Beyond the Tailor Rule. So, Emmy, 0:01:47.520 --> 0:01:49.320 thank you so much for coming on all lots, it's 0:01:49.320 --> 0:01:51.640 great to be here. Let's just start what is the. 0:01:51.640 --> 0:01:53.480 Tailor rule before we can go beyond it? 0:01:53.560 --> 0:01:57.520 Yeah, yeah, Well, in nineteen ninety three, John Taylor wrote 0:01:57.520 --> 0:02:00.520 a paper in which he showed that the behavior of 0:02:00.520 --> 0:02:03.680 the Federal Reserve could be described by this remarkably simple 0:02:03.760 --> 0:02:06.880 rule as a function of inflation and what people call 0:02:06.920 --> 0:02:08.680 the output gap, which is sort of a measure of 0:02:08.680 --> 0:02:12.359 how overheated the economy is. And this was very surprising 0:02:12.400 --> 0:02:15.080 to people because people typically think of what the Federal 0:02:15.120 --> 0:02:18.320 Reserve and other central banks do as incredibly complicated, and 0:02:18.360 --> 0:02:20.480 so the surprise was that you could actually describe it 0:02:20.520 --> 0:02:23.919 by something very simple. And since that time, when John 0:02:23.960 --> 0:02:27.280 Taylor wrote his original paper in nineteen ninety three, the 0:02:27.360 --> 0:02:30.640 tailor rule has achieved more or less mythical status within 0:02:30.800 --> 0:02:35.840 economics and the policymaking world. The original paper was mostly descriptive. 0:02:36.000 --> 0:02:38.280 Like I said, it was pointing out that the behavior 0:02:38.320 --> 0:02:41.160 of the Fed, which seemed complicated, could actually be described 0:02:41.160 --> 0:02:44.959 by something really simple. But since then it's really become 0:02:45.000 --> 0:02:49.560 a guide for prescriptive monetary policy. And when central banks 0:02:49.560 --> 0:02:52.120 deviate from the tailor rule, they're often asked to explain 0:02:52.200 --> 0:02:55.560 why this was a major theme in the post COVID 0:02:55.720 --> 0:02:57.280 inflation for example. 0:02:57.520 --> 0:02:59.959 So on that note, could I ask why the tale 0:03:00.320 --> 0:03:03.200 rules specifically and talk to us maybe about the process 0:03:03.360 --> 0:03:06.200 of how these papers come into being a head of 0:03:06.280 --> 0:03:07.000 Jackson hole. 0:03:07.680 --> 0:03:10.720 Why we wrote about the tailor rule. Well, as I said, 0:03:10.720 --> 0:03:15.000 the tailor rule has achieved this incredibly dominant status within 0:03:15.120 --> 0:03:18.080 not only the academic literature and monetari policy, but also 0:03:18.120 --> 0:03:23.040 within the policy community. And yet when I teach students, 0:03:23.080 --> 0:03:26.000 one of the things that's somewhat uncomfortable is that the 0:03:26.040 --> 0:03:28.959 tailor rule doesn't fit all that well over the past 0:03:29.040 --> 0:03:32.120 twenty years. So it fit pretty well during the Greenspan 0:03:32.280 --> 0:03:34.480 period and all the way until about two thousand and 0:03:34.520 --> 0:03:37.240 eight in the United States, but it hasn't fit very 0:03:37.240 --> 0:03:39.160 well since then. First of all, there was the zero 0:03:39.200 --> 0:03:41.440 lower bound period when interest rates were just at zero, 0:03:41.840 --> 0:03:44.720 but it also didn't predict very well either the timing 0:03:44.840 --> 0:03:47.720 or the magnitude of lift off from zero interest rates. 0:03:48.160 --> 0:03:50.920 So given that twenty years is starting to be a 0:03:50.960 --> 0:03:53.880 long time, the question is should we still view this 0:03:54.040 --> 0:03:57.320 as the benchmark for describing monetari policy. And then there's 0:03:57.360 --> 0:04:00.680 this second question about how to think about Goodmane type policy. 0:04:00.720 --> 0:04:04.320 So when John Taylor wrote his original paper, you know, 0:04:04.400 --> 0:04:06.600 it was mostly descriptive paper, but he did point out 0:04:06.760 --> 0:04:08.640 that this was a time period. The time period he 0:04:08.680 --> 0:04:11.280 said was actually only six years. It was from nineteen 0:04:11.400 --> 0:04:13.880 eighty seven to nineteen ninety two, But he pointed out 0:04:13.880 --> 0:04:15.320 that this was a time period a lot of people 0:04:15.360 --> 0:04:18.880 thought of as representing good monetary policy. So while the 0:04:18.880 --> 0:04:20.960 paper was mostly descriptive, he did say, you know, well, 0:04:20.960 --> 0:04:22.800 maybe this is a guiy to good mone type policy too, 0:04:22.800 --> 0:04:24.960 And that's a theme that a lot of people have 0:04:25.040 --> 0:04:27.080 picked up on since then, and we thought it was 0:04:27.120 --> 0:04:29.680 important to sort of reinvestigate that theme. 0:04:30.000 --> 0:04:32.640 But this is funny, right, like, because there is this 0:04:32.760 --> 0:04:35.200 tension of whether it's a descriptive or prescriptive thing. And 0:04:35.240 --> 0:04:37.520 I've heard for years people on TV it's like, oh, 0:04:37.640 --> 0:04:39.880 Taylor Roll says it should be a lot higher, or 0:04:39.920 --> 0:04:41.520 the tailor it should be lower. Whatever. 0:04:41.760 --> 0:04:44.359 We just heard it from Jeff Schmidt the Kansas Fed, right. 0:04:44.200 --> 0:04:47.680 And yet this is all based on basically a sort 0:04:47.720 --> 0:04:51.480 of backing out description of five years of monetary policy 0:04:51.480 --> 0:04:53.880 that six years, six years? Okay, sorry, six year maybe 0:04:53.960 --> 0:04:56.160 not quite So can you talk a little bit more 0:04:56.279 --> 0:04:59.279 about though this. I don't know if it's a debate 0:04:59.720 --> 0:05:03.960 or like, how people think about prescriptive versus descriptive within 0:05:04.040 --> 0:05:04.440 this role. 0:05:04.600 --> 0:05:07.600 So the tension that you're describing is exactly what motivated 0:05:07.680 --> 0:05:11.680 us to write this paper, because it's interesting how a 0:05:11.720 --> 0:05:14.240 framework like this, which is so simple and so powerful 0:05:14.520 --> 0:05:17.440 in terms of describing monetary policy and does say some 0:05:17.560 --> 0:05:20.880 things that are very true about what MONTEI policy should 0:05:20.920 --> 0:05:24.120 do in terms of leaning against inflation, leaning against an overheating. 0:05:24.160 --> 0:05:29.440 Overheating economy can end up becoming maybe more than even 0:05:29.480 --> 0:05:33.240 the author intended as a prescriptive rule. And one of 0:05:33.240 --> 0:05:35.320 the things that we want to remind people of is 0:05:35.360 --> 0:05:38.720 the historical context for when John Taylor's paper was written. 0:05:38.760 --> 0:05:40.880 So it was written in nineteen ninety three. This was 0:05:40.880 --> 0:05:43.600 a period when the FED was coming off some very 0:05:43.680 --> 0:05:46.680 difficult years for monetoi policy. So the nineteen seventies and 0:05:46.760 --> 0:05:50.120 nineteen eighties were very difficult years for monte policy. Inflation 0:05:50.240 --> 0:05:52.040 had been very high in the late nineteen seventies and 0:05:52.080 --> 0:05:57.159 early nineteen eighties. The Fed's reputation was, to say the 0:05:57.240 --> 0:06:02.200 least limited as an inflation fighter. Inflation expectations were not 0:06:02.520 --> 0:06:06.080 nearly as anchored as they are today. So it was 0:06:06.120 --> 0:06:08.080 a very different time, and I think some of the 0:06:08.080 --> 0:06:11.960 context for John Taylor's paper is saying that when you 0:06:12.120 --> 0:06:15.400 have those kinds of reputational challenges, sometimes you kind of 0:06:15.440 --> 0:06:17.839 need to tie yourself to a mask and say we 0:06:17.920 --> 0:06:18.560 are not going to. 0:06:18.640 --> 0:06:20.440 Go to a mathematical rule exactly. 0:06:20.720 --> 0:06:23.280 Because the nineteen seventies are also one of the time 0:06:23.320 --> 0:06:27.040 periods in history which is best known for political pressure 0:06:27.080 --> 0:06:30.240 on the FED, and so in the context of that 0:06:30.320 --> 0:06:32.680 kind of political pressure, one of the things you want 0:06:32.720 --> 0:06:35.679 to think about doing is giving people a very simple, 0:06:35.839 --> 0:06:39.880 observable metric for how you adjust interest rates. But then, 0:06:39.920 --> 0:06:43.960 of course, by you know, several decades later, the Fed's 0:06:44.040 --> 0:06:47.919 reputation had changed pretty dramatically. We had seen decades of 0:06:48.000 --> 0:06:51.480 low and stable inflation, and you know, the FED and 0:06:51.520 --> 0:06:55.039 other central banks around the world had really developed a 0:06:55.160 --> 0:06:59.080 very strong inflation fighting reputation. So then the question arises, 0:06:59.400 --> 0:07:02.640 is the same kind of tying your hands approach appropriate 0:07:03.040 --> 0:07:06.160 even in the context of you know, shocks like what 0:07:06.200 --> 0:07:08.880 we saw after COVID. And so this is the sense 0:07:08.880 --> 0:07:10.400 in which I think, you know, this is a time 0:07:10.560 --> 0:07:12.480 at which we want to ask these questions. 0:07:12.920 --> 0:07:15.000 It reminds me very much of the Psalm rule and 0:07:15.040 --> 0:07:18.120 the arguments there that if you find like a specific number, 0:07:18.240 --> 0:07:21.200 the ideas that you use a sort of simple formula 0:07:21.240 --> 0:07:24.440 and then you immediately jump into action. So on that note, 0:07:24.680 --> 0:07:26.720 one of the key things about the tailor rule is 0:07:26.760 --> 0:07:30.240 that it suggests rates need to rise by more than 0:07:30.360 --> 0:07:34.440 one for one with inflation to properly offset inflation, like 0:07:34.480 --> 0:07:37.320 you have to go in very very strong. But you 0:07:37.520 --> 0:07:40.640 found in your paper that that's not always the case exactly. 0:07:40.720 --> 0:07:43.520 So even beyond the idea that you want to raise 0:07:43.560 --> 0:07:46.600 interest rates more than one for one, so it's the 0:07:46.600 --> 0:07:48.680 coevision's one point five in the tailor rule. But there's 0:07:48.720 --> 0:07:51.160 the idea even beyond that of the tailor principle, which 0:07:51.200 --> 0:07:53.520 is exactly what you described, that you want to not 0:07:53.560 --> 0:07:56.680 only raise interest rates nominal interest rates with inflation, but 0:07:56.760 --> 0:07:58.400 you want to raise real interest rates. And if you 0:07:58.440 --> 0:07:59.920 want to raise real interest rates, then you have to 0:08:00.200 --> 0:08:02.559 is nominal interest rates more than one for one, exactly 0:08:02.600 --> 0:08:03.960 what you said, and so that's kind of a core 0:08:04.040 --> 0:08:07.480 idea and it's one of the main reasons why the 0:08:07.560 --> 0:08:11.520 gap between the tailor rule prescription and what central banks 0:08:11.600 --> 0:08:14.640 actually did during the COVID inflation was so large. And 0:08:14.680 --> 0:08:16.640 actually for the United States this gap was about it 0:08:16.760 --> 0:08:19.000 was over ten percentage points, so we are talking about 0:08:19.160 --> 0:08:21.480 a very large gap and the COVID inflation saw the 0:08:21.600 --> 0:08:25.640 largest gap in history. So why does that not actually 0:08:25.680 --> 0:08:29.400 happen always in monetary theory, Well, the reason is because 0:08:29.440 --> 0:08:32.520 there are different sources of inflation. So the motivation for 0:08:32.600 --> 0:08:35.920 leading hard against inflation that is probably pretty intuitive to 0:08:35.960 --> 0:08:39.480 most people is demand driven inflation. So when inflation is 0:08:39.520 --> 0:08:43.640 coming from an overheating economy, then there's this notion in 0:08:43.720 --> 0:08:47.440 monetary economics that you can satisfy all objectives of both 0:08:47.520 --> 0:08:50.040 kind of calming down the economy but also keeping inflation 0:08:50.080 --> 0:08:53.760 in check by raising interest rates pretty aggressively and actually 0:08:54.080 --> 0:08:56.520 optal monetary policy theory implies you might even want to 0:08:56.559 --> 0:08:59.199 be more aggressive than the tailor rule. But in contrast, 0:08:59.240 --> 0:09:01.800 when you have shot to inflation that don't come directly 0:09:01.800 --> 0:09:05.800 from an overheating economy but also come from you know, 0:09:05.840 --> 0:09:08.319 other sources of increases in costs, you know, so the 0:09:08.360 --> 0:09:11.400 supply shocks that people talked about during the COVID inflation period, 0:09:11.760 --> 0:09:15.679 then these same models can imply very different predictions. They 0:09:15.679 --> 0:09:18.760 can imply that you don't want to raise interest rates 0:09:18.800 --> 0:09:21.960 nearly so much in response to inflation associated with these 0:09:22.040 --> 0:09:24.280 kinds of shocks. So in our paper, what we do 0:09:24.440 --> 0:09:27.840 is we use a very standard monetary model, and we 0:09:27.920 --> 0:09:31.200 simulate data from this model where we assume that the 0:09:31.240 --> 0:09:34.520 monetary policy is actually exactly optimal, so the centerflike is 0:09:34.559 --> 0:09:37.400 really doing the right thing, and then we run regressions, 0:09:37.480 --> 0:09:39.800 you know, where we try to estimate what we get 0:09:39.800 --> 0:09:41.360 for the tailor role in this context. And then the 0:09:41.400 --> 0:09:44.240 interesting observation is that you find that actually a lot 0:09:44.280 --> 0:09:47.600 of times the coefficient on inflation is less than one. 0:09:47.920 --> 0:09:50.080 Sometimes it's close to zero, sometimes it's even negative. So 0:09:50.280 --> 0:09:53.319 really a lot of things can happen when you deviate 0:09:53.559 --> 0:09:56.160 only from this view of inflation is coming from an 0:09:56.160 --> 0:10:10.880 overheating economy. 0:10:12.920 --> 0:10:14.080 Did the FED do a good job? 0:10:14.840 --> 0:10:17.040 The paper reads like vindication. 0:10:16.720 --> 0:10:19.559 Yeah, because I think in twenty twenty five there's still 0:10:19.600 --> 0:10:21.480 plenty of fights about this question, what's your fake? 0:10:21.720 --> 0:10:25.200 I think in so we don't know what's going to happen. Yeah, 0:10:25.840 --> 0:10:28.000 but I think in the long span of history, if 0:10:28.040 --> 0:10:30.360 you look at what happened over the past five years, 0:10:30.400 --> 0:10:32.040 I think this is going to look like a soft landing, 0:10:32.800 --> 0:10:36.760 and that is typically exactly what the Federal Reserve is 0:10:36.800 --> 0:10:40.959 trying to achieve. So, I mean, obviously, the FED appropriately 0:10:41.000 --> 0:10:43.880 and private sector forecasters took a lot of flak for 0:10:44.000 --> 0:10:47.240 saying that inflation was going to be very transitory when 0:10:47.280 --> 0:10:50.920 inflation was significantly more persistent. That said, inflation did come 0:10:50.960 --> 0:10:55.120 down very quickly, and there hasn't been a recession, and 0:10:55.240 --> 0:10:58.840 that is remarkable. Not only has there not been a recession, 0:10:59.040 --> 0:11:01.040 and not only didn't place and come down very quickly, 0:11:01.080 --> 0:11:04.760 but longer term inflation expectations really did not become unhinged. 0:11:04.800 --> 0:11:09.880 Despite this historic increase in inflation, we haven't seen large 0:11:09.920 --> 0:11:13.240 increases in longer term bond yields. So this is all 0:11:13.600 --> 0:11:16.720 pretty remarkable, and I would think that if things go 0:11:16.840 --> 0:11:19.400 well over the next five years, that in the longer 0:11:19.440 --> 0:11:20.920 at amount of history, this is going. 0:11:20.800 --> 0:11:21.880 To look like a big success. 0:11:22.320 --> 0:11:26.679 So this is where central bank independence and credibility actually 0:11:26.679 --> 0:11:29.600 comes into play when it comes to those longer term 0:11:29.720 --> 0:11:35.079 inflation expectations. How did you actually measure credibility in this paper? 0:11:35.120 --> 0:11:36.959 Because you don't look just at the FED, you look 0:11:36.960 --> 0:11:37.840 at a bunch of other. 0:11:37.679 --> 0:11:41.120 Central banks, right, So when we look at other central banks, 0:11:41.640 --> 0:11:43.319 one of the things we point out is that there 0:11:43.360 --> 0:11:46.000 was a huge amount of variation in terms of how 0:11:46.120 --> 0:11:50.040 different central banks reacted to the COVID inflation. So we've 0:11:50.080 --> 0:11:53.960 been talking about the United States and similarly countries like Japan, 0:11:54.160 --> 0:11:57.560 the UK, the Euro Area. These countries all raised interest 0:11:57.640 --> 0:12:02.240 rates very gradually and by very moderate amounts relative to 0:12:02.320 --> 0:12:05.440 the size of the inflation increases they were facing, and 0:12:05.480 --> 0:12:07.760 so they all took a lot of flack for raising 0:12:07.800 --> 0:12:10.800 interest rates too slowly, for being behind the curve, for 0:12:10.840 --> 0:12:13.520 not raising interest rates enough. And these are the countries 0:12:13.559 --> 0:12:17.320 we refer to in our paper as late risers because 0:12:17.320 --> 0:12:19.360 they were late to the game right. But there were 0:12:19.440 --> 0:12:21.760 other countries in the world we referred to as early 0:12:21.880 --> 0:12:25.400 risers who raised interest rates a lot more aggressively and 0:12:25.520 --> 0:12:29.880 a lot earlier. And the interesting observation. You might have 0:12:29.920 --> 0:12:33.199 thought that these countries would have suffered from the fact 0:12:33.440 --> 0:12:35.720 the late riser countries would have suffered from the fact 0:12:35.720 --> 0:12:38.480 that they relate to the game in raising interest rates 0:12:38.480 --> 0:12:41.440 with having higher inflation than the early risers who responded 0:12:41.480 --> 0:12:44.679 very aggressively, and in fact we find the opposite. So 0:12:44.720 --> 0:12:47.560 the early risers did respond very aggressively the COVID inflation, 0:12:47.679 --> 0:12:50.560 but they actually saw inflation rise by a lot more 0:12:50.640 --> 0:12:53.000 during this episode. So then we asked the question, well, 0:12:53.000 --> 0:12:55.080 what could explain that seems sort of backwards? You know, 0:12:55.120 --> 0:12:57.240 you have these countries that seemed to have responded very 0:12:57.280 --> 0:12:59.959 aggressively with interest rates and yet they saw the large 0:13:00.120 --> 0:13:03.520 and more persistent inflationary surges. But then what we see 0:13:03.640 --> 0:13:07.199 is that those same countries are countries that have much 0:13:07.360 --> 0:13:11.800 more checkered inflation histories. So you asked about reputation, Well, 0:13:11.840 --> 0:13:15.560 a very simple way to ask about the reputation of 0:13:15.640 --> 0:13:18.280 a central bank for controlling inflation is just to look 0:13:18.360 --> 0:13:21.920 at average inflation in the recent decades. And so we 0:13:22.000 --> 0:13:25.199 look at average inflation over the previous three decades, and 0:13:25.240 --> 0:13:28.480 we see that the early riser countries, the ones that 0:13:28.800 --> 0:13:31.439 you know probably felt they had to respond ery aggressively 0:13:31.480 --> 0:13:35.800 to the COVID inflation, also had much more checkered inflation histories. 0:13:35.840 --> 0:13:39.240 They had much higher average inflation over the past three 0:13:39.280 --> 0:13:42.760 decades previous to COVID, And so I think a natural 0:13:42.800 --> 0:13:46.240 interpretation of these facts is that for these countries, they 0:13:46.280 --> 0:13:50.400 did not feel that they had the inflation fighting credibility 0:13:51.000 --> 0:13:53.679 of the central banks in the United States or in 0:13:53.760 --> 0:13:56.040 Japan or in the Euro Area. They did not feel 0:13:56.040 --> 0:13:59.640 that they had the kind of strongly anchored inflation expectations 0:13:59.720 --> 0:14:02.920 that these countries could benefit from. And so for these countries, 0:14:02.920 --> 0:14:05.560 it really probably was not an option to think that 0:14:05.600 --> 0:14:09.439 they could look through the inflation and yet keep inflation 0:14:09.520 --> 0:14:13.120 expectations anchored. But yet that is actually what happened in 0:14:13.360 --> 0:14:16.160 the United States and several other of these late riser countries. 0:14:16.440 --> 0:14:19.760 So I find this to be really fascinating. I want 0:14:19.800 --> 0:14:22.360 to get to the question of like whether the develop 0:14:22.440 --> 0:14:25.200 market or the US is like ground down its stock 0:14:25.240 --> 0:14:27.000 of credibility over the last five years, But I wanted 0:14:27.000 --> 0:14:30.600 to on this question of the early risers. I get 0:14:30.640 --> 0:14:33.160 what you're saying, but it's still not intuitive to me 0:14:33.880 --> 0:14:36.640 that the countries or the central banks with a sort 0:14:36.640 --> 0:14:40.880 of mediocre history of controlling inflation this time around were 0:14:40.920 --> 0:14:44.280 really on the ball in unison. I mean, I would 0:14:44.320 --> 0:14:47.080 think that if a central bank has a history of 0:14:47.280 --> 0:14:50.600 missing its inflation target or letting inflation rise, that at 0:14:50.680 --> 0:14:52.760 least some of them would have done it again. They 0:14:52.760 --> 0:14:55.720 would have come in late, because that's what they do institutionally. 0:14:55.800 --> 0:14:58.960 Like how consistent is this process around the world, whereby 0:14:59.000 --> 0:15:02.200 the countries that have a track record were early risers 0:15:02.200 --> 0:15:02.680 this time. 0:15:02.560 --> 0:15:05.240 Around, right, So we're not including every country, So there 0:15:05.240 --> 0:15:08.280 are some countries which are outliers in terms of their 0:15:09.320 --> 0:15:11.280 in terms of their response in terms of their inflation. 0:15:11.840 --> 0:15:13.280 But I think one of the things you have to 0:15:13.320 --> 0:15:16.480 recognize is that in the world as a whole, there 0:15:16.520 --> 0:15:19.480 has been quite a remarkable sort of triumph of central 0:15:19.480 --> 0:15:22.840 banks over inflation. So back in the nineteen seventies and 0:15:22.920 --> 0:15:26.800 nineteen eighties, almost every country was like what we see 0:15:26.800 --> 0:15:29.600 in the early risers today. So none of these countries 0:15:29.720 --> 0:15:34.280 had really strong credentials as inflation fighters. And more recently 0:15:34.960 --> 0:15:36.640 there are a number of these countries which are kind 0:15:36.640 --> 0:15:39.840 of moving in the direction of having much stronger inflation 0:15:40.000 --> 0:15:43.480 fighting credentials. But at the same time, you know, these 0:15:43.520 --> 0:15:47.080 are countries where it's a relatively fresh history, you know. 0:15:47.160 --> 0:15:48.840 So you look at some of these countries where they 0:15:48.840 --> 0:15:51.800 had pretty high inflation in the past, yeah, and you know, 0:15:51.800 --> 0:15:53.640 and there's just sort of starting to be able to 0:15:53.640 --> 0:15:55.640 get over it. And then the question is do you 0:15:55.720 --> 0:15:58.600 think that the public will be willing to watch you 0:15:58.680 --> 0:16:02.760 go through a period of say, ten percent inflation and say, oh, 0:16:02.840 --> 0:16:05.080 we're sure you're going to get it back to two percent, 0:16:05.480 --> 0:16:06.880 or do you think you know, there's going to be 0:16:07.040 --> 0:16:08.280 real question of whether you're going to be able to 0:16:08.280 --> 0:16:08.640 achieve that. 0:16:09.240 --> 0:16:11.480 Okay, So if on the other hand, you do have 0:16:11.560 --> 0:16:15.400 good credibility, you do have a good history of inflation fighting, 0:16:15.600 --> 0:16:19.080 then you can kind of spend that social capital, I guess, 0:16:19.480 --> 0:16:22.800 and avoid having to raise interest rates by as much 0:16:22.840 --> 0:16:25.520 as you know, maybe another central bank that doesn't have 0:16:25.560 --> 0:16:29.680 that credibility walk us through what exactly are the benefits 0:16:29.920 --> 0:16:31.320 of not having to do. 0:16:31.200 --> 0:16:36.040 That, of not having to raise race rise Absolutely well, 0:16:36.040 --> 0:16:39.920 you get closer to optimal monetary policy. So in the models, 0:16:40.000 --> 0:16:43.520 you know, the basic idea is, for example, if you 0:16:43.600 --> 0:16:45.640 have one of these cost push shocks, where there's a 0:16:45.680 --> 0:16:49.000 shock that is going directly to inflation because of increases 0:16:49.040 --> 0:16:52.280 in costs or bottlenecks of various types, or you have 0:16:52.320 --> 0:16:55.440 a shock like during COVID to people's demand for goods 0:16:55.480 --> 0:16:58.600 versus services. If you raise the interest rate dramatically, like 0:16:58.600 --> 0:17:00.520 the tailor rum might have predicted you, it is interesting 0:17:00.560 --> 0:17:02.680 to ten percent. So what's going to have to happen 0:17:02.920 --> 0:17:05.440 to get inflation down to zero in the short run. Well, 0:17:05.440 --> 0:17:07.040 maybe you're going to have to have a big recession. 0:17:07.160 --> 0:17:09.240 You're going to have to have one part of the 0:17:09.280 --> 0:17:10.840 economy completely collapse. 0:17:11.119 --> 0:17:13.399 You know, Trump will tweet at you more or post 0:17:13.440 --> 0:17:14.280 on truth social more. 0:17:14.480 --> 0:17:17.600 Probably you're going to have to have really negative inflation 0:17:17.680 --> 0:17:19.320 in some sectors of the economy, and you're going to 0:17:19.359 --> 0:17:22.240 have to have a big recession. And potentially, you know 0:17:22.280 --> 0:17:24.400 the other issue is that there's a lot of evidence 0:17:24.400 --> 0:17:29.240 suggesting that monetary policy has pretty delayed effects. So another concern, 0:17:29.560 --> 0:17:32.040 and as I said, you know in this episode, professional 0:17:32.040 --> 0:17:35.240 forecasters and the FED both thought that the inflation would 0:17:35.280 --> 0:17:38.360 be more transitory than it actually was. But another concern 0:17:38.720 --> 0:17:41.920 is if you think that the shocks that are causing 0:17:41.960 --> 0:17:44.600 the inflation are sort of going to dissipate on their own, 0:17:44.680 --> 0:17:46.760 and you think that monetary policy has going to take 0:17:46.800 --> 0:17:49.240 some time to have an effect, then one of the 0:17:49.280 --> 0:17:52.480 concerns is that by the time the monetary policy actually 0:17:52.480 --> 0:17:55.000 has a large effect, then you know, some of these 0:17:55.000 --> 0:17:57.560 shocks are going to dissipate. And then I guess the 0:17:57.600 --> 0:18:01.760 third thing I would mention is that in theory, the 0:18:01.800 --> 0:18:04.639 central bank actually wants to use a combination not only 0:18:04.680 --> 0:18:07.800 of current interest rate movements but also a forward guidance. 0:18:08.080 --> 0:18:10.800 So this is one of the big innovations in monetary 0:18:10.920 --> 0:18:14.359 policy over recent decades. We think about forward guidance a 0:18:14.400 --> 0:18:17.160 lot in the context of the zero lower bound, when 0:18:17.240 --> 0:18:19.760 you can't do anything with FED funds rate, and so 0:18:19.800 --> 0:18:22.359 it's all about forward guidance, but actually forward guidance is 0:18:22.359 --> 0:18:25.600 a much much more general phenomenon. It's really whenever the 0:18:25.600 --> 0:18:28.399 central bank is calling it shots about what it's going 0:18:28.440 --> 0:18:30.560 to do with interest rates, even over the next year. 0:18:30.720 --> 0:18:35.000 So this was hugely important during the COVID inflation research, 0:18:35.119 --> 0:18:40.160 because the FED started talking about raising interest rates and 0:18:40.280 --> 0:18:43.600 a longer term bond yield started rising pretty rapidly in 0:18:43.680 --> 0:18:47.160 late twenty twenty one, substantially before the FED funds rate 0:18:47.160 --> 0:18:51.399 actually started to rise rapidly. And in the theory, a 0:18:51.440 --> 0:18:53.840 central bank that has that power, it has the ability 0:18:53.880 --> 0:18:56.800 to affect the economy not just through what it does 0:18:57.080 --> 0:19:00.119 with the FED funds rate, but also through its words 0:19:00.160 --> 0:19:02.480 an impact on the bond market. Through that channel, we'll 0:19:02.480 --> 0:19:05.480 actually want to use both. And so that's another advantage 0:19:05.560 --> 0:19:07.440 of not being bound by these kinds of constraints. 0:19:07.440 --> 0:19:10.840 The strikes me is an incredibly important point, which is 0:19:11.000 --> 0:19:14.840 that you can tighten monetary policy by talking, by saying, 0:19:15.119 --> 0:19:18.080 and so that just by looking at that overnight rate 0:19:18.160 --> 0:19:21.720 that the rule might anticipate, et cetera, does not necessarily 0:19:21.800 --> 0:19:24.639 capture the stance of monetary at that time if you're 0:19:24.640 --> 0:19:28.239 already indicated and you're pulling forward those raid hikes. So 0:19:28.320 --> 0:19:30.080 do we have less credibility today? 0:19:30.200 --> 0:19:30.399 You know? 0:19:30.520 --> 0:19:33.040 So, Okay, maybe the FED did a good job in 0:19:33.040 --> 0:19:36.919 this time. Nonetheless, there was this very big inflationary episode, 0:19:36.920 --> 0:19:40.440 et cetera. So after years of very cool inflation, finally 0:19:40.520 --> 0:19:43.600 we got a big one. Going forward, does that mean 0:19:43.680 --> 0:19:46.560 the next time around, if there is another inflationary shock 0:19:46.640 --> 0:19:50.520 for whatever reason, that the FED might be impelled to 0:19:50.560 --> 0:19:52.879 be more of an early riser than it felt in 0:19:52.920 --> 0:19:53.399 this cycle. 0:19:53.720 --> 0:19:57.240 I would think almost definitely yes. Remember that going into 0:19:57.520 --> 0:20:02.080 the COVID inflation, you know, regular pe hadn't seen significant 0:20:02.080 --> 0:20:06.320 amounts of inflation for years. It just wasn't really part 0:20:06.480 --> 0:20:10.200 of the mindset of anyone. You know, when you saw, 0:20:10.280 --> 0:20:14.840 for example, unions, in wage negotiations or other contexts things 0:20:14.840 --> 0:20:17.240 where inflation should have been relevant, it was sort of 0:20:17.280 --> 0:20:20.320