Speaker 1: Bloomberg Audio Studios, Podcasts, Radio News.
Speaker 2: Hello and welcome to another episode of the Authoughts podcast.
Speaker 2: I'm Tracy Alloway.
Speaker 3: And I'm Joe. Why isn't thal Joe?
Speaker 2: We're back in Jackson Hall.
Speaker 3: Jackson Hall. I love it here.
Speaker 2: It's beautiful. It's beautiful, And not only do we get
Speaker 2: a chance to enjoy the gorgeous scenery, we get a
Speaker 2: chance to talk economic policy.
Speaker 3: There's so much going on right now. To see the least,
Speaker 3: we don't need to recapituate. Everyone knows what's going on
Speaker 3: right now. There's so much stuff, whether we're talking about
Speaker 3: macro situation, whether we're talking about whatever.
Speaker 2: I love how you say there's no need to recapitulate
Speaker 2: and then you immediately do it.
Speaker 3: Well, there's just so much going on.
Speaker 2: I think you're hitting on like a couple things. Which
Speaker 2: is there are these different themes floating through the conference,
Speaker 2: So obviously you have uncertainty over what tariffs actually do
Speaker 2: to the economy, like what type of shock are they?
Speaker 2: Do they destroy demand and therefore maybe cause deflation, or
Speaker 2: do they lead to companies passing on those costs and
Speaker 2: cause inflation. There's central bank independence, which everyone wants to
Speaker 2: talk about. And there's obviously the direction of short term
Speaker 2: interest rates.
Speaker 3: And then of course the formal and then of course
Speaker 3: the formal theme of the conference about labor, labor markets
Speaker 3: and all this stuff. So yes, many different things.
Speaker 2: Going on, all right, Well, I am very pleased to
Speaker 2: say that there is in fact one paper that ties
Speaker 2: basically all these themes together. So we have the author
Speaker 2: here and really the perfect guest to Jehan.
Speaker 3: We've wanted to talk to for a long time.
Speaker 2: Absolutely, we're going to be speaking with Emmy Nakamura, a
Speaker 2: professor at Berkeley and the author of a paper being
Speaker 2: presented at Jackson Hole called Beyond the Tailor Rule. So, Emmy,
Speaker 2: thank you so much for coming on all lots, it's
Speaker 2: great to be here. Let's just start what is the.
Speaker 3: Tailor rule before we can go beyond it?
Speaker 4: Yeah, yeah, Well, in nineteen ninety three, John Taylor wrote
Speaker 4: a paper in which he showed that the behavior of
Speaker 4: the Federal Reserve could be described by this remarkably simple
Speaker 4: rule as a function of inflation and what people call
Speaker 4: the output gap, which is sort of a measure of
Speaker 4: how overheated the economy is. And this was very surprising
Speaker 4: to people because people typically think of what the Federal
Speaker 4: Reserve and other central banks do as incredibly complicated, and
Speaker 4: so the surprise was that you could actually describe it
Speaker 4: by something very simple. And since that time, when John
Speaker 4: Taylor wrote his original paper in nineteen ninety three, the
Speaker 4: tailor rule has achieved more or less mythical status within
Speaker 4: economics and the policymaking world. The original paper was mostly descriptive.
Speaker 4: Like I said, it was pointing out that the behavior
Speaker 4: of the Fed, which seemed complicated, could actually be described
Speaker 4: by something really simple. But since then it's really become
Speaker 4: a guide for prescriptive monetary policy. And when central banks
Speaker 4: deviate from the tailor rule, they're often asked to explain
Speaker 4: why this was a major theme in the post COVID
Speaker 4: inflation for example.
Speaker 2: So on that note, could I ask why the tale
Speaker 2: rules specifically and talk to us maybe about the process
Speaker 2: of how these papers come into being a head of
Speaker 2: Jackson hole.
Speaker 4: Why we wrote about the tailor rule. Well, as I said,
Speaker 4: the tailor rule has achieved this incredibly dominant status within
Speaker 4: not only the academic literature and monetari policy, but also
Speaker 4: within the policy community. And yet when I teach students,
Speaker 4: one of the things that's somewhat uncomfortable is that the
Speaker 4: tailor rule doesn't fit all that well over the past
Speaker 4: twenty years. So it fit pretty well during the Greenspan
Speaker 4: period and all the way until about two thousand and
Speaker 4: eight in the United States, but it hasn't fit very
Speaker 4: well since then. First of all, there was the zero
Speaker 4: lower bound period when interest rates were just at zero,
Speaker 4: but it also didn't predict very well either the timing
Speaker 4: or the magnitude of lift off from zero interest rates.
Speaker 4: So given that twenty years is starting to be a
Speaker 4: long time, the question is should we still view this
Speaker 4: as the benchmark for describing monetari policy. And then there's
Speaker 4: this second question about how to think about Goodmane type policy.
Speaker 4: So when John Taylor wrote his original paper, you know,
Speaker 4: it was mostly descriptive paper, but he did point out
Speaker 4: that this was a time period. The time period he
Speaker 4: said was actually only six years. It was from nineteen
Speaker 4: eighty seven to nineteen ninety two, But he pointed out
Speaker 4: that this was a time period a lot of people
Speaker 4: thought of as representing good monetary policy. So while the
Speaker 4: paper was mostly descriptive, he did say, you know, well,
Speaker 4: maybe this is a guiy to good mone type policy too,
Speaker 4: And that's a theme that a lot of people have
Speaker 4: picked up on since then, and we thought it was
Speaker 4: important to sort of reinvestigate that theme.
Speaker 3: But this is funny, right, like, because there is this
Speaker 3: tension of whether it's a descriptive or prescriptive thing. And
Speaker 3: I've heard for years people on TV it's like, oh,
Speaker 3: Taylor Roll says it should be a lot higher, or
Speaker 3: the tailor it should be lower. Whatever.
Speaker 2: We just heard it from Jeff Schmidt the Kansas Fed, right.
Speaker 3: And yet this is all based on basically a sort
Speaker 3: of backing out description of five years of monetary policy
Speaker 3: that six years, six years? Okay, sorry, six year maybe
Speaker 3: not quite So can you talk a little bit more
Speaker 3: about though this. I don't know if it's a debate
Speaker 3: or like, how people think about prescriptive versus descriptive within
Speaker 3: this role.
Speaker 4: So the tension that you're describing is exactly what motivated
Speaker 4: us to write this paper, because it's interesting how a
Speaker 4: framework like this, which is so simple and so powerful
Speaker 4: in terms of describing monetary policy and does say some
Speaker 4: things that are very true about what MONTEI policy should
Speaker 4: do in terms of leaning against inflation, leaning against an overheating.
Speaker 4: Overheating economy can end up becoming maybe more than even
Speaker 4: the author intended as a prescriptive rule. And one of
Speaker 4: the things that we want to remind people of is
Speaker 4: the historical context for when John Taylor's paper was written.
Speaker 4: So it was written in nineteen ninety three. This was
Speaker 4: a period when the FED was coming off some very
Speaker 4: difficult years for monetoi policy. So the nineteen seventies and
Speaker 4: nineteen eighties were very difficult years for monte policy. Inflation
Speaker 4: had been very high in the late nineteen seventies and
Speaker 4: early nineteen eighties. The Fed's reputation was, to say the
Speaker 4: least limited as an inflation fighter. Inflation expectations were not
Speaker 4: nearly as anchored as they are today. So it was
Speaker 4: a very different time, and I think some of the
Speaker 4: context for John Taylor's paper is saying that when you
Speaker 4: have those kinds of reputational challenges, sometimes you kind of
Speaker 4: need to tie yourself to a mask and say we
Speaker 4: are not going to.
Speaker 3: Go to a mathematical rule exactly.
Speaker 4: Because the nineteen seventies are also one of the time
Speaker 4: periods in history which is best known for political pressure
Speaker 4: on the FED, and so in the context of that
Speaker 4: kind of political pressure, one of the things you want
Speaker 4: to think about doing is giving people a very simple,
Speaker 4: observable metric for how you adjust interest rates. But then,
Speaker 4: of course, by you know, several decades later, the Fed's
Speaker 4: reputation had changed pretty dramatically. We had seen decades of
Speaker 4: low and stable inflation, and you know, the FED and
Speaker 4: other central banks around the world had really developed a
Speaker 4: very strong inflation fighting reputation. So then the question arises,
Speaker 4: is the same kind of tying your hands approach appropriate
Speaker 4: even in the context of you know, shocks like what
Speaker 4: we saw after COVID. And so this is the sense
Speaker 4: in which I think, you know, this is a time
Speaker 4: at which we want to ask these questions.
Speaker 2: It reminds me very much of the Psalm rule and
Speaker 2: the arguments there that if you find like a specific number,
Speaker 2: the ideas that you use a sort of simple formula
Speaker 2: and then you immediately jump into action. So on that note,
Speaker 2: one of the key things about the tailor rule is
Speaker 2: that it suggests rates need to rise by more than
Speaker 2: one for one with inflation to properly offset inflation, like
Speaker 2: you have to go in very very strong. But you
Speaker 2: found in your paper that that's not always the case exactly.
Speaker 4: So even beyond the idea that you want to raise
Speaker 4: interest rates more than one for one, so it's the
Speaker 4: coevision's one point five in the tailor rule. But there's
Speaker 4: the idea even beyond that of the tailor principle, which
Speaker 4: is exactly what you described, that you want to not
Speaker 4: only raise interest rates nominal interest rates with inflation, but
Speaker 4: you want to raise real interest rates. And if you
Speaker 4: want to raise real interest rates, then you have to
Speaker 4: is nominal interest rates more than one for one, exactly
Speaker 4: what you said, and so that's kind of a core
Speaker 4: idea and it's one of the main reasons why the
Speaker 4: gap between the tailor rule prescription and what central banks
Speaker 4: actually did during the COVID inflation was so large. And
Speaker 4: actually for the United States this gap was about it
Speaker 4: was over ten percentage points, so we are talking about
Speaker 4: a very large gap and the COVID inflation saw the
Speaker 4: largest gap in history. So why does that not actually
Speaker 4: happen always in monetary theory, Well, the reason is because
Speaker 4: there are different sources of inflation. So the motivation for
Speaker 4: leading hard against inflation that is probably pretty intuitive to
Speaker 4: most people is demand driven inflation. So when inflation is
Speaker 4: coming from an overheating economy, then there's this notion in
Speaker 4: monetary economics that you can satisfy all objectives of both
Speaker 4: kind of calming down the economy but also keeping inflation
Speaker 4: in check by raising interest rates pretty aggressively and actually
Speaker 4: optal monetary policy theory implies you might even want to
Speaker 4: be more aggressive than the tailor rule. But in contrast,
Speaker 4: when you have shot to inflation that don't come directly
Speaker 4: from an overheating economy but also come from you know,
Speaker 4: other sources of increases in costs, you know, so the
Speaker 4: supply shocks that people talked about during the COVID inflation period,
Speaker 4: then these same models can imply very different predictions. They
Speaker 4: can imply that you don't want to raise interest rates
Speaker 4: nearly so much in response to inflation associated with these
Speaker 4: kinds of shocks. So in our paper, what we do
Speaker 4: is we use a very standard monetary model, and we
Speaker 4: simulate data from this model where we assume that the
Speaker 4: monetary policy is actually exactly optimal, so the centerflike is
Speaker 4: really doing the right thing, and then we run regressions,
Speaker 4: you know, where we try to estimate what we get
Speaker 4: for the tailor role in this context. And then the
Speaker 4: interesting observation is that you find that actually a lot
Speaker 4: of times the coefficient on inflation is less than one.
Speaker 4: Sometimes it's close to zero, sometimes it's even negative. So
Speaker 4: really a lot of things can happen when you deviate
Speaker 4: only from this view of inflation is coming from an
Speaker 4: overheating economy.
Speaker 3: Did the FED do a good job?
Speaker 2: The paper reads like vindication.
Speaker 3: Yeah, because I think in twenty twenty five there's still
Speaker 3: plenty of fights about this question, what's your fake?
Speaker 4: I think in so we don't know what's going to happen. Yeah,
Speaker 4: but I think in the long span of history, if
Speaker 4: you look at what happened over the past five years,
Speaker 4: I think this is going to look like a soft landing,
Speaker 4: and that is typically exactly what the Federal Reserve is
Speaker 4: trying to achieve. So, I mean, obviously, the FED appropriately
Speaker 4: and private sector forecasters took a lot of flak for
Speaker 4: saying that inflation was going to be very transitory when
Speaker 4: inflation was significantly more persistent. That said, inflation did come
Speaker 4: down very quickly, and there hasn't been a recession, and
Speaker 4: that is remarkable. Not only has there not been a recession,
Speaker 4: and not only didn't place and come down very quickly,
Speaker 4: but longer term inflation expectations really did not become unhinged.
Speaker 4: Despite this historic increase in inflation, we haven't seen large
Speaker 4: increases in longer term bond yields. So this is all
Speaker 4: pretty remarkable, and I would think that if things go
Speaker 4: well over the next five years, that in the longer
Speaker 4: at amount of history, this is going.
Speaker 3: To look like a big success.
Speaker 2: So this is where central bank independence and credibility actually
Speaker 2: comes into play when it comes to those longer term
Speaker 2: inflation expectations. How did you actually measure credibility in this paper?
Speaker 2: Because you don't look just at the FED, you look
Speaker 2: at a bunch of other.
Speaker 4: Central banks, right, So when we look at other central banks,
Speaker 4: one of the things we point out is that there
Speaker 4: was a huge amount of variation in terms of how
Speaker 4: different central banks reacted to the COVID inflation. So we've
Speaker 4: been talking about the United States and similarly countries like Japan,
Speaker 4: the UK, the Euro Area. These countries all raised interest
Speaker 4: rates very gradually and by very moderate amounts relative to
Speaker 4: the size of the inflation increases they were facing, and
Speaker 4: so they all took a lot of flack for raising
Speaker 4: interest rates too slowly, for being behind the curve, for
Speaker 4: not raising interest rates enough. And these are the countries
Speaker 4: we refer to in our paper as late risers because
Speaker 4: they were late to the game right. But there were
Speaker 4: other countries in the world we referred to as early
Speaker 4: risers who raised interest rates a lot more aggressively and
Speaker 4: a lot earlier. And the interesting observation. You might have
Speaker 4: thought that these countries would have suffered from the fact
Speaker 4: the late riser countries would have suffered from the fact
Speaker 4: that they relate to the game in raising interest rates
Speaker 4: with having higher inflation than the early risers who responded
Speaker 4: very aggressively, and in fact we find the opposite. So
Speaker 4: the early risers did respond very aggressively the COVID inflation,
Speaker 4: but they actually saw inflation rise by a lot more
Speaker 4: during this episode. So then we asked the question, well,
Speaker 4: what could explain that seems sort of backwards? You know,
Speaker 4: you have these countries that seemed to have responded very
Speaker 4: aggressively with interest rates and yet they saw the large
Speaker 4: and more persistent inflationary surges. But then what we see
Speaker 4: is that those same countries are countries that have much
Speaker 4: more checkered inflation histories. So you asked about reputation, Well,
Speaker 4: a very simple way to ask about the reputation of
Speaker 4: a central bank for controlling inflation is just to look
Speaker 4: at average inflation in the recent decades. And so we
Speaker 4: look at average inflation over the previous three decades, and
Speaker 4: we see that the early riser countries, the ones that
Speaker 4: you know probably felt they had to respond ery aggressively
Speaker 4: to the COVID inflation, also had much more checkered inflation histories.
Speaker 4: They had much higher average inflation over the past three
Speaker 4: decades previous to COVID, And so I think a natural
Speaker 4: interpretation of these facts is that for these countries, they
Speaker 4: did not feel that they had the inflation fighting credibility
Speaker 4: of the central banks in the United States or in
Speaker 4: Japan or in the Euro Area. They did not feel
Speaker 4: that they had the kind of strongly anchored inflation expectations
Speaker 4: that these countries could benefit from. And so for these countries,
Speaker 4: it really probably was not an option to think that
Speaker 4: they could look through the inflation and yet keep inflation
Speaker 4: expectations anchored. But yet that is actually what happened in
Speaker 4: the United States and several other of these late riser countries.
Speaker 3: So I find this to be really fascinating. I want
Speaker 3: to get to the question of like whether the develop
Speaker 3: market or the US is like ground down its stock
Speaker 3: of credibility over the last five years, But I wanted
Speaker 3: to on this question of the early risers. I get
Speaker 3: what you're saying, but it's still not intuitive to me
Speaker 3: that the countries or the central banks with a sort
Speaker 3: of mediocre history of controlling inflation this time around were
Speaker 3: really on the ball in unison. I mean, I would
Speaker 3: think that if a central bank has a history of
Speaker 3: missing its inflation target or letting inflation rise, that at
Speaker 3: least some of them would have done it again. They
Speaker 3: would have come in late, because that's what they do institutionally.
Speaker 3: Like how consistent is this process around the world, whereby
Speaker 3: the countries that have a track record were early risers
Speaker 3: this time.
Speaker 4: Around, right, So we're not including every country, So there
Speaker 4: are some countries which are outliers in terms of their
Speaker 4: in terms of their response in terms of their inflation.
Speaker 4: But I think one of the things you have to
Speaker 4: recognize is that in the world as a whole, there
Speaker 4: has been quite a remarkable sort of triumph of central
Speaker 4: banks over inflation. So back in the nineteen seventies and
Speaker 4: nineteen eighties, almost every country was like what we see
Speaker 4: in the early risers today. So none of these countries
Speaker 4: had really strong credentials as inflation fighters. And more recently
Speaker 4: there are a number of these countries which are kind
Speaker 4: of moving in the direction of having much stronger inflation
Speaker 4: fighting credentials. But at the same time, you know, these
Speaker 4: are countries where it's a relatively fresh history, you know.
Speaker 4: So you look at some of these countries where they
Speaker 4: had pretty high inflation in the past, yeah, and you know,
Speaker 4: and there's just sort of starting to be able to
Speaker 4: get over it. And then the question is do you
Speaker 4: think that the public will be willing to watch you
Speaker 4: go through a period of say, ten percent inflation and say, oh,
Speaker 4: we're sure you're going to get it back to two percent,
Speaker 4: or do you think you know, there's going to be
Speaker 4: real question of whether you're going to be able to
Speaker 4: achieve that.
Speaker 2: Okay, So if on the other hand, you do have
Speaker 2: good credibility, you do have a good history of inflation fighting,
Speaker 2: then you can kind of spend that social capital, I guess,
Speaker 2: and avoid having to raise interest rates by as much
Speaker 2: as you know, maybe another central bank that doesn't have
Speaker 2: that credibility walk us through what exactly are the benefits
Speaker 2: of not having to do.
Speaker 4: That, of not having to raise race rise Absolutely well,
Speaker 4: you get closer to optimal monetary policy. So in the models,
Speaker 4: you know, the basic idea is, for example, if you
Speaker 4: have one of these cost push shocks, where there's a
Speaker 4: shock that is going directly to inflation because of increases
Speaker 4: in costs or bottlenecks of various types, or you have
Speaker 4: a shock like during COVID to people's demand for goods
Speaker 4: versus services. If you raise the interest rate dramatically, like
Speaker 4: the tailor rum might have predicted you, it is interesting
Speaker 4: to ten percent. So what's going to have to happen
Speaker 4: to get inflation down to zero in the short run. Well,
Speaker 4: maybe you're going to have to have a big recession.
Speaker 4: You're going to have to have one part of the
Speaker 4: economy completely collapse.
Speaker 2: You know, Trump will tweet at you more or post
Speaker 2: on truth social more.
Speaker 4: Probably you're going to have to have really negative inflation
Speaker 4: in some sectors of the economy, and you're going to
Speaker 4: have to have a big recession. And potentially, you know
Speaker 4: the other issue is that there's a lot of evidence
Speaker 4: suggesting that monetary policy has pretty delayed effects. So another concern,
Speaker 4: and as I said, you know in this episode, professional
Speaker 4: forecasters and the FED both thought that the inflation would
Speaker 4: be more transitory than it actually was. But another concern
Speaker 4: is if you think that the shocks that are causing
Speaker 4: the inflation are sort of going to dissipate on their own,
Speaker 4: and you think that monetary policy has going to take
Speaker 4: some time to have an effect, then one of the
Speaker 4: concerns is that by the time the monetary policy actually
Speaker 4: has a large effect, then you know, some of these
Speaker 4: shocks are going to dissipate. And then I guess the
Speaker 4: third thing I would mention is that in theory, the
Speaker 4: central bank actually wants to use a combination not only
Speaker 4: of current interest rate movements but also a forward guidance.
Speaker 4: So this is one of the big innovations in monetary
Speaker 4: policy over recent decades. We think about forward guidance a
Speaker 4: lot in the context of the zero lower bound, when
Speaker 4: you can't do anything with FED funds rate, and so
Speaker 4: it's all about forward guidance, but actually forward guidance is
Speaker 4: a much much more general phenomenon. It's really whenever the
Speaker 4: central bank is calling it shots about what it's going
Speaker 4: to do with interest rates, even over the next year.
Speaker 4: So this was hugely important during the COVID inflation research,
Speaker 4: because the FED started talking about raising interest rates and
Speaker 4: a longer term bond yield started rising pretty rapidly in
Speaker 4: late twenty twenty one, substantially before the FED funds rate
Speaker 4: actually started to rise rapidly. And in the theory, a
Speaker 4: central bank that has that power, it has the ability
Speaker 4: to affect the economy not just through what it does
Speaker 4: with the FED funds rate, but also through its words
Speaker 4: an impact on the bond market. Through that channel, we'll
Speaker 4: actually want to use both. And so that's another advantage
Speaker 4: of not being bound by these kinds of constraints.
Speaker 3: The strikes me is an incredibly important point, which is
Speaker 3: that you can tighten monetary policy by talking, by saying,
Speaker 3: and so that just by looking at that overnight rate
Speaker 3: that the rule might anticipate, et cetera, does not necessarily
Speaker 3: capture the stance of monetary at that time if you're
Speaker 3: already indicated and you're pulling forward those raid hikes. So
Speaker 3: do we have less credibility today?
Speaker 4: You know?
Speaker 3: So, Okay, maybe the FED did a good job in
Speaker 3: this time. Nonetheless, there was this very big inflationary episode,
Speaker 3: et cetera. So after years of very cool inflation, finally
Speaker 3: we got a big one. Going forward, does that mean
Speaker 3: the next time around, if there is another inflationary shock
Speaker 3: for whatever reason, that the FED might be impelled to
Speaker 3: be more of an early riser than it felt in
Speaker 3: this cycle.
Speaker 4: I would think almost definitely yes. Remember that going into
Speaker 4: the COVID inflation, you know, regular pe hadn't seen significant
Speaker 4: amounts of inflation for years. It just wasn't really part
Speaker 4: of the mindset of anyone. You know, when you saw,
Speaker 4: for example, unions, in wage negotiations or other contexts things
Speaker 4: where inflation should have been relevant, it was sort of
Speaker 4: striking that it just wasn't on anyone's mind. And it
Speaker 4: even took a while after the inflation started for people
Speaker 4: to even think about this, because it had become so
Speaker 4: much of a non issue for so many years that
Speaker 4: it was just not part of the mental frame of Americans.
Speaker 4: I see this very much when I teach students, because
Speaker 4: for American students, typically I have to do a lot
Speaker 4: of work to just explain the difference, for example, between
Speaker 4: a nominal interest rate and a real interest.
Speaker 2: I did not earn interest on my bank account for
Speaker 2: most of my adult life, so.
Speaker 4: I see exactly. But in contrast, for Latin American students,
Speaker 4: they get in immediately because it's just part of how
Speaker 4: they grew up, right, And I think that that distinction
Speaker 4: has probably blurred at least a little bit, right because
Speaker 4: now people have gone through a few years where it
Speaker 4: mattered to pay a little bit of attention to inflation.
Speaker 4: And so my guess is that if we start to
Speaker 4: see inflation again, it's going to be, you know, a
Speaker 4: much more rapid transition to where people will start to
Speaker 4: ask whether this is going to last longer, whether now
Speaker 4: that we've seen you know, two inflationary episodes in the
Speaker 4: recent past, whether this is sort of the new normal.
Speaker 4: You know. I think it's important not to forget how
Speaker 4: hard one those expectations of low inflation were for the
Speaker 4: Federal Reserve in many other countries. You know, it's certainly
Speaker 4: something that can dissipate.
Speaker 2: So, because we're dealing with the tailor rule, which basically,
Speaker 2: you know, suggests or describes either way, what the central
Speaker 2: bank should do with interest rates in response to inflation
Speaker 2: and changes in the output gap. We're talking basically about
Speaker 2: like the impact of shocks to that output gap. There's
Speaker 2: a nuance here because like shocks can be different and
Speaker 2: have different effects on the output gap. What type of
Speaker 2: shock would tariffs be? I know this isn't the subject
Speaker 2: of your paper, but you know your gut instinct, how
Speaker 2: would you describe tariffs in terms of that economic shock
Speaker 2: and the impact on output?
Speaker 4: So there have been a number of recent academic papers
Speaker 4: on this. It's not the focus of our paper, but
Speaker 4: I think that the overall message of those papers is
Speaker 4: that you do want to look through sort of the
Speaker 4: initial impact of the tariffs, but you don't want to
Speaker 4: look through sort of second round effects. So to the
Speaker 4: extent that you start to see an effect in terms
Speaker 4: of longer run inflation expectations becoming unhinged and so on,
Speaker 4: that's the part of the inflation that the central bank
Speaker 4: would want to be responding aggressively to.
Speaker 3: I have another question that maybe outside the scope of
Speaker 3: this specific paper, but.
Speaker 2: It has a lot of relevance to today.
Speaker 3: There's a lot when you think about around the world,
Speaker 3: some central banks have more credibility than some others. Is
Speaker 3: it that the good central banks just had like smarter,
Speaker 3: better economists, advising them better on policy than the other ones.
Speaker 3: Or does it have more to do with the political
Speaker 3: conditions that allow a central bank to operate separately from
Speaker 3: to essentially operate with independent agency, And is that more
Speaker 3: of a thing that originates in the political sphere of
Speaker 3: those countries.
Speaker 4: I think clearly the politics is very important. I guess
Speaker 4: it would point to two things. One is those difficult
Speaker 4: decades of the nineteen seventies and nineteen eighties which occurred
Speaker 4: in many countries around the world, and where people in
Speaker 4: these countries realized how much they hated inflation. We got
Speaker 4: a little bit of a taste of this during the
Speaker 4: COVID inflation. Inflation just is incredibly unpopular. And it was
Speaker 4: for this reason that it was possible in the United
Speaker 4: States to appoint Paul Wolker as chairman of the thing,
Speaker 4: even though it was known before he was appointed what
Speaker 4: he was going to do, that he was going to
Speaker 4: raise interest rates aggressively, that this was going to be painful,
Speaker 4: And so that's a remarkable thing that it was actually
Speaker 4: possible to make this appointment. But of course similar things
Speaker 4: actually happened in other countries as well. There were similar
Speaker 4: appointments of aggressive, you know, central bankers that controlled inflation.
Speaker 4: So I think part of this did come out of,
Speaker 4: you know, sort of a public reaction to inflation. But
Speaker 4: at the same time, it didn't happen everywhere, just like
Speaker 4: you said, and could only have been in the context
Speaker 4: of political protection for the central central bank independence and
Speaker 4: perhaps in some ways it's just sort of a remarkable
Speaker 4: thing that it ever did happen, that we've seen this
Speaker 4: long period of low inflation in many of these countries.
Speaker 3: I something realized I've heard over the years at various
Speaker 3: times where we're deviations from the Taylor rule, whether it
Speaker 3: was the zero lower boundar era or it couldn't lower them,
Speaker 3: or more recently, how far were they off in the
Speaker 3: seventies when inflation was going crazy? There is there a
Speaker 3: good measure of like, no, clearly they should have been higher.
Speaker 3: This like, what does the tailor rules say about that?
Speaker 4: The nineteen seventies very interesting because one of the things
Speaker 4: we point out in our paper is that the predictions
Speaker 4: and the prescriptions of the Tailor rule are of course
Speaker 4: only as good as the inputs you put into them.
Speaker 4: And one of the things that some of the academic
Speaker 4: literatures pointed out is that you don't necessarily want to
Speaker 4: use the data that we have today on something like
Speaker 4: the output gap, because views about the output gap, that is,
Speaker 4: you know, how overheating is the economy have changed over time,
Speaker 4: and in particular, in the nineteen seventies, the Federal Reserve
Speaker 4: was pretty optimistic about the potential output of the US economy,
Speaker 4: and for that reason, its judgment about the output gap
Speaker 4: was pretty negative. And this helps to explain, through the
Speaker 4: lens of the tailor rule, why they had pretty dubvish
Speaker 4: monetary policy in the nineteen seventies. So actually, if you
Speaker 4: take the real time data on what the FED said
Speaker 4: it thought the output gap was at the time I'm
Speaker 4: along with inflation, then you get more or less what
Speaker 4: they did and what happened in terms of, you know,
Speaker 4: why many people think that the policy was two douvison
Speaker 4: in the nineteen seventies has a lot to do whether
Speaker 4: you think those measures of the output gap were reasonable,
Speaker 4: and you know, the current estimates according to the Fed,
Speaker 4: you know, are much less sort of dubvish than they
Speaker 4: were at the time. But it highlights the fact that
Speaker 4: even when you want to create a rule which is
Speaker 4: sort of very technocratic and doesn't give you any wiggle room.
Speaker 4: That's not entirely true, because something like the output gap
Speaker 4: is not something that you can just read off a
Speaker 4: statistic like inflation. Actually you can, and so as a consequence,
Speaker 4: you know, it really matters what judgment you take about
Speaker 4: where you are relative to the economy's potential.
Speaker 3: You can never escape human you never quite escape human judgment, unfortunately.
Speaker 2: I remember that the output gap debate was a big
Speaker 2: thing after two thousand and eight as well. Okay, just
Speaker 2: going back to the idea of this technocratic rule, whether
Speaker 2: it's scriptive or descriptive, I know people have different opinions
Speaker 2: on that, but supposedly one of the benefits of it
Speaker 2: being possibly prescriptive was that you have a central bank
Speaker 2: that like does a very expected thing, like you know
Speaker 2: what the reaction function is and you know what they're
Speaker 2: going to do in response to inflation. How does that
Speaker 2: play into the credibility aspect, because on the other hand,
Speaker 2: you know, more credible central banks, they can kind of
Speaker 2: go off and do their own thing, go beyond the
Speaker 2: tailor rule, as you put it in the paper. But
Speaker 2: on the other hand, does that unexpected behavior perhaps have
Speaker 2: an impact on their own credibility, even if it's successful
Speaker 2: in the short term.
Speaker 4: Absolutely, I mean, I think that the technocratic rules, like
Speaker 4: the tailor rule, they absolutely have a place in the
Speaker 4: canon of monetary policy. And you know, perhaps one could
Speaker 4: even argue that they should be the default in response
Speaker 4: to many kinds of inflationary episodes, because there are many
Speaker 4: kinds of inflationary episodes, like those associated with excessive demand,
Speaker 4: you know, an overheating economy and all so even worse,
Speaker 4: just sort of self fulfilling worries about inflation that spiral
Speaker 4: off into really serious inflationary episodes. So in response to
Speaker 4: all of those kinds of episodes, you know, it may
Speaker 4: may be a very good idea for people to be
Speaker 4: able to expect that central bank is going to respond
Speaker 4: aggressively along the lines of something like the tailor rule.
Speaker 4: And there's a sense in which you might want to
Speaker 4: think about going beyond the tailor rule as something that
Speaker 4: you don't do all the time, but that you recognize
Speaker 4: has to happen some of the time when you have
Speaker 4: a strong sense that a different kind of shock is
Speaker 4: hitting the economy, and in some of those episodes, you
Speaker 4: might actually want to very explicitly use forward guidance. So,
Speaker 4: for example, during the Great Recession, that was a period
Speaker 4: when there was you know, some of the most explicit
Speaker 4: usage of forward guidance to talk about the timing of
Speaker 4: how long the FED was going to keep interest rates
Speaker 4: at zero, and that was a very powerful tool in
Speaker 4: terms of affecting longer term interest rates. It's very easy
Speaker 4: to see that in the data. And that's the kind
Speaker 4: of thing where you know, it's not about going away
Speaker 4: from reputation, which it's true. That core idea is that
Speaker 4: you want markets to absolutely be confident that the central
Speaker 4: bank is going to respond aggressively to any sense of
Speaker 4: de anchoring of inflation expectations, and that is very important,
Speaker 4: but at times you may want to use for guidance
Speaker 4: in other ways, and the response of the fad to
Speaker 4: the Great Recession as an example of that.
Speaker 3: I just have one last question, and it's kind of selfish.
Speaker 3: So you're talking about, you know, different sources of inflation,
Speaker 3: whether it's access demand or whether it's supply. Tracy and
Speaker 3: I did like a ton of podcast episodes in twenty
Speaker 3: twenty one twenty twenty two about supply chains. We talked
Speaker 3: about the ports and all this stuff that you know,
Speaker 3: but someone could say, you guys were missing the forest
Speaker 3: for the trees. Distress at the ports wasn't about supply
Speaker 3: Chaine was because there was too much demand. Distress at
Speaker 3: the X factory was it because of some supply chain
Speaker 3: or missing part. There was just too much demand. You
Speaker 3: guys were just disguised ueeing demand problems by focusing on
Speaker 3: choke points that are inevitably going to emerge when booming demand.
Speaker 3: I still think about this. I'm like, oh, should we
Speaker 3: have focused on you know, I'm like, but you have
Speaker 3: described a lot of this inflation, and part of the
Speaker 3: reason for the Meca disinflation is because a lot of
Speaker 3: it was supply defense. You know, I'm looking for a
Speaker 3: defense of all this focus that we did on the
Speaker 3: supply side.
Speaker 4: So I think you're you're right that there's kind of
Speaker 4: a false dichotomy between talking about demand shocks and things
Speaker 4: like supply constraints, you know, like the ports and the
Speaker 4: Suez Canal and so on, Because you're right that if
Speaker 4: you have too much demand then at some point, you know,
Speaker 4: these supply chains get clocked, and so it's it's it's
Speaker 4: absolutely right that those kinds of supply constraints are not
Speaker 4: quite the same as supply shocks, right, But there are
Speaker 4: other things which are just directly shocked.
Speaker 3: The war in Ukraine was a shocked.
Speaker 4: Exactly, and COVID, for example, generated all sorts of sort
Speaker 4: of negative productivity throughout the economy that just made things
Speaker 4: more expensive to produce in a variety of ways. So
Speaker 4: these are some of the things that I think are
Speaker 4: genuinely basically negative productivity shocks, which were sort of hard
Speaker 4: to find examples of previous to COVID, but easy to
Speaker 4: find examples of during COVID.
Speaker 2: How could are policy makers at identifying types of shocks
Speaker 2: in real time?
Speaker 4: That is a very important question. And you know, I
Speaker 4: think my discussion of the nineteen seventies and the fact
Speaker 4: that you know, views have changed over time about the
Speaker 4: output gap during that period and also during the COVID inflation,
Speaker 4: you know, views of change shows that this is by
Speaker 4: no means perfect. But at the same time, I think
Speaker 4: there are times when there's a strong sense that, you know,
Speaker 4: the COVID inflation, for example, wasn't just about you know,
Speaker 4: self fulfilling inflation expectations or something like this, And so
Speaker 4: that's where I want to emphasize this idea that there's
Speaker 4: a difference between saying that we can always identify the
Speaker 4: shocks with confidence, which clearly we cannot, and saying that
Speaker 4: we can never identify any shocks, you know, to the
Speaker 4: extent that we need to tire ours all the time
Speaker 4: to a mechanical rule, which you know, may deviate from
Speaker 4: what theory really says is opt to a monetary policy.
Speaker 4: But again, you know, I think crucial ideas is all
Speaker 4: of this has to take place against the background where
Speaker 4: there's sort of confidence in the central banks commitment to
Speaker 4: longer run inflation stability.
Speaker 2: All right, Emmy Nakhimura, thank you so much. This was
Speaker 2: a real treat for us. I kind of want to
Speaker 2: go to Berkeley now.
Speaker 3: Yeah, I know it's a I did.
Speaker 1: So.
Speaker 3: That was amazing. Thank you so much. That was fantastic.
Speaker 2: Thank you. That was great. Joe, that was fantastic. I
Speaker 2: really enjoyed that conversation. And Emmy has a remarkable way
Speaker 2: of explaining like some complicated concepts, yeah, very simply and
Speaker 2: in a real understandable way, because if you flip through
Speaker 2: her paper, there's a lot of formulas and things like that.
Speaker 2: So it looks complicated, but she explained it very.
Speaker 3: Clearly, incredibly clearly. I had the same thing. I was like, oh, man,
Speaker 3: it would be so nice to just be like a
Speaker 3: student and like alert, you know, get to a student.
Speaker 3: Sounds very fun but incredibly clear. And you know, she's,
Speaker 3: you know, one of the foremost inflation experts in sort
Speaker 3: of academia. And so to hear her sort of like
Speaker 3: sort of summation of how she thinks about the last
Speaker 3: five years and the lessons learned from it was like
Speaker 3: a real treat Yeah.
Speaker 2: And obviously there are a couple of takeaways there. So one,
Speaker 2: it is incredibly hard for policy or often incredibly hard
Speaker 2: for policy makers to identify shocks, you know, at the
Speaker 2: moment that they're happening, but sometimes they can, like in
Speaker 2: COVID And I guess the second takeaway is the importance
Speaker 2: of credibility. Yeah, right, And if you manage to successfully
Speaker 2: control inflation for years and years and decades or whatever,
Speaker 2: you build up that social capital which then allows you
Speaker 2: to be somewhat more flexible when you have another crisis.
Speaker 3: Yeah. I thought that was very interesting. Also, there are
Speaker 3: a couple other things that's struck me. First of all,
Speaker 3: until reading this paper. And this is just my fault
Speaker 3: because I could look this up at any time. I
Speaker 3: hadn't realized that the tailor rule was built up six
Speaker 3: years of data. There's like, Okay, this is the rule
Speaker 3: that describes when a central bank.
Speaker 2: Is a monetary policy.
Speaker 3: Basically, this is the rule that sort of describes what
Speaker 3: a well functioning central bank looks like is basically six years.
Speaker 3: You know. That's interesting. That's interesting to me too. And
Speaker 3: second of all, this idea that even though it does
Speaker 3: look like a hard rule, that you can't escape the
Speaker 3: fact that you have to judge the output gap. And
Speaker 3: there were very big debates about the size of the
Speaker 3: output gap after two thousand and eight and two thousand
Speaker 3: and nine, very sharp disagreements about the capacity or what
Speaker 3: full employment looked like. So even that doesn't fully solve you.
Speaker 3: Even if you do tie yourself to the lash of
Speaker 3: a hard rule or lash yourself to the mast of
Speaker 3: a hard rule, the tough problem.
Speaker 2: Still yeah, it's it's tough, all right, leave it there,
Speaker 2: Let's leave it there. This has been another episode of
Speaker 2: the Odd Lots podcast. I'm Tracy Alloway. You can follow
Speaker 2: me at Tracy Alloway.
Speaker 3: And I'm Jill Wisenthal. You can follow me at the Stalwart.
Speaker 3: If you want to read Emmy's paper, go check out
Speaker 3: the Kansas City Fed's website. Follow our producers Kerman Rodriguez
Speaker 3: at Kerman armand Dashel Bennett at Dashbot and Kilbrooks at Kilbrooks.
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