August 29, 2025 • 36 mins
The post-Covid inflation will prove to be a treasure trove for academic economists, as they study what drives inflation, and the power that central banks have to contain it once it gets going. At this year's Jackson Hole Economic Symposium, UC Berkeley professor Emi Nakamura presented a new paper — co-authored with her Berkeley colleagues Jón Steinsson and Venance Riblier — titled Beyond the Taylor Rule. The paper sought to look at the wide range of choices that global central banks made in dealing with inflation to see what if anything could be learned about the Taylor Rule, a load-bearing idea in modern economics that describes what optimal monetary policy looks like when successfully balancing the Federal Reserve's objectives. Their paper discovers that in any bout of inflation, a central bank that has a greater history of fighting inflation also has the ability to deviate further from strict Taylor Rule guidelines, without achieving worse inflation outcomes. In an interview recorded in Jackson Hole, we speak with Professor Nakamura about her work and its implications for central bankers going forward.
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Speaker 1 (00:02):
Bloomberg Audio Studios, Podcasts, Radio News.
Speaker 2 (00:18):
Hello and welcome to another episode of the Authoughts podcast.
I'm Tracy Alloway.
Speaker 3 (00:22):
And I'm Joe. Why isn't thal Joe?
Speaker 2 (00:23):
We're back in Jackson Hall.
Speaker 3 (00:25):
Jackson Hall. I love it here.
Speaker 2 (00:26):
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.
Speaker 3 (00:34):
There's so much going on right now. To see the least,
we don't need to recapituate. 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.
Speaker 2 (00:44):
I love how you say there's no need to recapitulate
and then you immediately do it.
Speaker 3 (00:48):
Well, there's just so much going on.
Speaker 2 (00:49):
I think you're hitting on like a couple 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, like 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
(01:11):
talk about. And there's obviously the direction of short term
interest rates.
Speaker 3 (01:15):
And then of course the formal and then of course
the formal theme of the conference about labor, labor markets
and all this stuff. So yes, many different things.
Speaker 2 (01:22):
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 Jehan.
Speaker 3 (01:35):
We've wanted to talk to for a long time.
Speaker 2 (01:37):
Absolutely, we're going to be speaking with Emmy Nakamura, a
professor at Berkeley and the author of a paper being
presented at Jackson Hole called Beyond the Tailor Rule. So, Emmy,
thank you so much for coming on all lots, it's
great to be here. Let's just start what is the.
Speaker 3 (01:51):
Tailor rule before we can go beyond it?
Speaker 4 (01:53):
Yeah, yeah, Well, in nineteen ninety three, 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
(02:15):
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 nineteen ninety three, the
tailor rule has achieved more or less mythical status within
economics and the policymaking world. The original paper was mostly descriptive.
(02:36):
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 tailor rule, they're often asked to explain
why this was a major theme in the post COVID
inflation for example.
Speaker 2 (02:57):
So on that note, could I ask why the tale
rules specifically and talk to us maybe about the process
of how these papers come into being a head of
Jackson hole.
Speaker 4 (03:07):
Why we wrote about the tailor rule. Well, as I said,
the tailor rule has achieved this incredibly dominant status within
not only the academic literature and monetari policy, but also
within the policy community. And yet when I teach students,
one of the things that's somewhat uncomfortable is that the
tailor rule doesn't fit all that well over the past
(03:29):
twenty years. So it fit pretty well during the Greenspan
period and all the way until about two thousand and
eight 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 lift off from zero interest rates.
So given that twenty years is starting to be a
(03:50):
long time, the question is should we still view this
as the benchmark for describing monetari policy. And then there's
this second question about how to think about Goodmane type 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 nineteen
(04:11):
eighty seven to nineteen ninety two, 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 guiy to good mone type policy too,
And 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.
Speaker 3 (04:30):
But this is funny, right, like, 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,
Taylor Roll says it should be a lot higher, or
the tailor it should be lower. Whatever.
Speaker 2 (04:41):
We just heard it from Jeff Schmidt the Kansas Fed, right.
Speaker 3 (04:44):
And yet this is all based on basically a sort
of backing out description of five years of monetary policy
that six years, six years? Okay, sorry, six year maybe
not quite So can you talk a little bit more
about though this. I don't know if it's a debate
or like, how people think about prescriptive versus descriptive within
this role.
Speaker 4 (05:04):
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 MONTEI policy should
do in terms of leaning against inflation, leaning against an overheating.
Overheating economy can end up becoming maybe more than even
(05:29):
the author intended as a prescriptive rule. And 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 nineteen ninety three. This was
a period when the FED was coming off some very
difficult years for monetoi policy. So the nineteen seventies and
nineteen eighties were very difficult years for monte policy. Inflation
(05:50):
had been very high in the late nineteen seventies and
early nineteen eighties. 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
(06:12):
have those kinds of reputational challenges, sometimes you kind of
need to tie yourself to a mask and say we
are not going to.
Speaker 3 (06:18):
Go to a mathematical rule exactly.
Speaker 4 (06:20):
Because the nineteen seventies 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 you know, several decades later, the Fed's
(06:44):
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. 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
(07:06):
we saw after COVID. And so this is the sense
in which I think, you know, this is a time
at which we want to ask these questions.
Speaker 2 (07:12):
It reminds me very much of the Psalm rule and
the arguments there that if you find like a specific number,
the ideas 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 tailor rule is
that it suggests rates need to rise by more than
one for one with inflation to properly offset inflation, like
(07:34):
you have to go in very very strong. But you
found in your paper that that's not always the case exactly.
Speaker 4 (07:40):
So even beyond the idea that you want to raise
interest rates more than one for one, so it's the
coevision's one point five in the tailor rule. But there's
the idea even beyond that of the tailor 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. And if you
want to raise real interest rates, then you have to
is nominal interest rates more than one for one, exactly
(08:02):
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 tailor rule prescription and what central banks
actually did during the COVID inflation was so large. And
actually for the United States this gap was about it
was over ten 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
(08:25):
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. So when inflation is
coming from an overheating economy, then there's this notion in
monetary economics that you can satisfy all objectives of both
(08:47):
kind of calming down the economy but also keeping inflation
in check by raising interest rates pretty aggressively and actually
optal monetary policy theory implies you might even want to
be more aggressive than the tailor rule. But in contrast,
when you have shot to inflation that don't come directly
from an overheating economy but also come from you know,
other sources of increases in costs, you know, so the
(09:08):
supply shocks that people talked about during the COVID inflation period,
then these same models can imply very different predictions. They
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
(09:31):
monetary policy is actually exactly optimal, so the centerflike is
really doing the right thing, and then we run regressions,
you know, where we try to estimate what we get
for the tailor role 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.
Sometimes it's close to zero, sometimes it's even negative. So
really a lot of things can happen when you deviate
(09:53):
only from this view of inflation is coming from an
overheating economy.
Speaker 3 (10:12):
Did the FED do a good job?
Speaker 2 (10:14):
The paper reads like vindication.
Speaker 3 (10:16):
Yeah, because I think in twenty twenty five there's still
plenty of fights about this question, what's your fake?
Speaker 4 (10:21):
I think in so we don't know what's going to happen. Yeah,
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 flak for
(10:44):
saying that inflation was going to be very transitory when
inflation was significantly more persistent. That said, inflation did come
down very quickly, and there hasn't been a recession, and
that is remarkable. Not only has there not been a recession,
and not only didn't place and come down very quickly,
but longer term inflation expectations really did not become unhinged.
(11:04):
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
at amount of history, this is going.
Speaker 3 (11:20):
To look like a big success.
Speaker 2 (11:22):
So this is where central bank independence and credibility actually
comes into play when it comes to those longer term
inflation expectations. How did you actually measure credibility in this paper?
Because you don't look just at the FED, you look
at a bunch of other.
Speaker 4 (11:37):
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
(12:02):
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. And these are the countries
we refer to in our paper as late risers because
they were late to the game right. But there were
other countries in the world we referred to as early
risers who raised interest rates a lot more aggressively and
(12:25):
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 relate 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. So
the early risers did respond very aggressively the COVID inflation,
(12:47):
but they actually saw inflation rise by a lot more
during this episode. So then we asked the question, well,
what could explain that seems sort of backwards? You know,
you have these countries that seemed to have responded very
aggressively with interest rates and yet they saw the large
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,
(13:11):
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. And so we
look at average inflation over the previous three decades, and
we see that the early riser countries, the ones that
you know probably felt they had to respond ery aggressively
to the COVID inflation, also had much more checkered inflation histories.
(13:35):
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
(13:56):
that they had the kind of strongly anchored inflation expectations
that these countries could benefit from. And so for these countries,
it really probably was not an option to think that
they could look through 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.
Speaker 3 (14:16):
So I find this to be really fascinating. I want
to get to the question of like whether the develop
market or the US is like ground down its stock
of credibility over the last five years, But I wanted
to 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
(14:36):
of mediocre history of controlling inflation this time around were
really on the ball in unison. I 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.
Like how consistent is this process around the world, whereby
(14:59):
the countries that have a track record were early risers
this time.
Speaker 4 (15:02):
Around, right, So we're not including every country, So there
are some countries which are outliers in terms of their
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. So back in the nineteen seventies and
(15:22):
nineteen eighties, 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
(15:43):
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, yeah, and you know,
and there's just sort of starting to be able to
get over it. And then the question is do you
think that the public will be willing to watch you
go through a period of say, ten percent inflation and say, oh,
we're sure you're going to get it back to two percent,
(16:05):
or do you think you know, there's going to be
real question of whether you're going to be able to
achieve that.
Speaker 2 (16:09):
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 you know, maybe another central bank that doesn't have
that credibility walk us through what exactly are the benefits
(16:29):
of not having to do.
Speaker 4 (16:31):
That, of not having to raise race rise Absolutely well,
you get closer to optimal monetary policy. So in the models,
you know, 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
(16:52):
a shock like during COVID to people's demand for goods
versus services. If you raise the interest rate dramatically, like
the tailor rum might have predicted you, it is interesting
to ten percent. So what's going to have to happen
to get inflation down to zero in the short run. Well,
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.
Speaker 2 (17:11):
You know, Trump will tweet at you more or post
on truth social more.
Speaker 4 (17:14):
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
(17:35):
be more transitory than it actually was. But 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 has going to take
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 you know, some of these
shocks are going to dissipate. And then I guess the
(17:57):
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 a forward guidance.
So this is one of the big innovations in monetary
policy over recent decades. We think about forward guidance a
lot in the context of the zero lower bound, when
you can't do anything with FED funds rate, and so
(18:19):
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 it shots about what it's going
to do with interest rates, even over the next year.
So this was hugely important during the COVID inflation research,
because the FED started talking about raising interest rates and
(18:40):
a longer term bond yield started rising pretty rapidly in
late twenty twenty one, substantially before the FED funds rate
actually started to rise rapidly. And 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
an impact on the bond market. Through that channel, we'll
(19:02):
actually want to use both. And so that's another advantage
of not being bound by these kinds of constraints.
Speaker 3 (19:07):
The strikes me is an incredibly important point, which is
that you can tighten monetary policy by talking, by saying,
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're
already indicated and you're pulling forward those raid hikes. So
(19:28):
do we have less credibility today?
Speaker 4 (19:30):
You know?
Speaker 3 (19:30):
So, Okay, 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
(19:50):
be more of an early riser than it felt in
this cycle.
Speaker 4 (19:53):
I would think almost definitely yes. Remember that going into
the COVID inflation, you know, regular pe hadn't seen significant
amounts of inflation for years. It just wasn't really part
of the mindset of anyone. You know, when you saw,
for example, unions, in wage negotiations or other contexts things
(20:14):
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
(20:37):
of work to just explain the difference, for example, between
a nominal interest rate and a real interest.
Speaker 2 (20:41):
I did not earn interest on my bank account for
most of my adult life, so.
Speaker 4 (20:46):
I see exactly. But in contrast, for Latin American students,
they get in 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
(21:06):
see inflation again, it's going to be, you know, 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 you know, two inflationary episodes in the
recent past, whether this is sort of the new normal.
You know. I think it's important not to forget how
hard one those expectations of low inflation were for the
(21:29):
Federal Reserve in many other countries. You know, it's certainly
something that can dissipate.
Speaker 2 (21:35):
So, because we're dealing with the tailor 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
(21:57):
have different effects on the output gap. What type of
shock would tariffs be? I know this isn't the subject
of your paper, but you know your gut instinct, how
would you describe tariffs in terms of that economic shock
and the impact on output?
Speaker 4 (22:10):
So there have been a number of recent academic papers
on this. It's not the focus of our paper, but
I think that the overall message of those papers is
that you do want to look through sort of the
initial impact of the tariffs, but you don't want to
look through sort of second round effects. So to the
extent that you start to see an effect in terms
of longer run inflation expectations becoming unhinged and so on,
(22:33):
that's the part of the inflation that the central bank
would want to be responding aggressively to.
Speaker 3 (22:53):
I have another question that maybe outside the scope of
this specific paper, but.
Speaker 2 (22:58):
It has a lot of relevance to today.
Speaker 3 (23:00):
There's a lot when you think about around the world,
some central banks have more credibility than some others. Is
it that the good central banks just had like smarter,
better economists, advising them better on policy than the other ones.
Or does it have more to do with the political
conditions that allow a central bank to operate separately from
(23:22):
to essentially operate with independent agency, And is that more
of a thing that originates in the political sphere of
those countries.
Speaker 4 (23:28):
I think clearly the politics is very important. I guess
it would point to two things. One is those difficult
decades of the nineteen seventies and nineteen eighties which occurred
in many countries around the world, and where people in
these countries realized how much they hated inflation. We got
a little bit of a taste of this during the
COVID inflation. Inflation just is incredibly unpopular. And it was
(23:54):
for this reason that it was possible in the United
States to appoint Paul Wolker as chairman of the thing,
even though it was known before he was appointed what
he was going to do, that he was going to
raise interest rates aggressively, that this was going to be painful,
And so that's a remarkable thing that it was actually
possible to make this appointment. But of course similar things
actually happened in other countries as well. There were similar
(24:17):
appointments of aggressive, you know, central bankers that controlled inflation.
So I think part of this did come out of,
you know, sort of a public reaction to inflation. But
at the same time, it didn't happen everywhere, just like
you said, and could only have been in the context
of political protection for the central central bank independence and
(24:38):
perhaps in some ways it's just sort of a remarkable
thing that it ever did happen, that we've seen this
long period of low inflation in many of these countries.
Speaker 3 (24:45):
I something realized I've heard over the years at various
times where we're deviations from the Taylor rule, whether it
was the zero lower boundar era or it couldn't lower them,
or more recently, how far were they off in the
seventies when inflation was going crazy? There is there a
good measure of like, no, clearly they should have been higher.
This like, what does the tailor rules say about that?
Speaker 4 (25:07):
The nineteen seventies very interesting because one of the things
we point out in our paper is that the predictions
and the prescriptions of the Tailor rule are of course
only as good as the inputs you put into them.
And one of the things that some of the academic
literatures pointed out is that you don't necessarily want to
use the data that we have today on something like
the output gap, because views about the output gap, that is,
(25:30):
you know, how overheating is the economy have changed over time,
and in particular, in the nineteen seventies, the Federal Reserve
was pretty optimistic about the potential output of the US economy,
and for that reason, its judgment about the output gap
was pretty negative. And this helps to explain, through the
lens of the tailor rule, why they had pretty dubvish
(25:51):
monetary policy in the nineteen seventies. So actually, if you
take the real time data on what the FED said
it thought the output gap was at the time I'm
along with inflation, then you get more or less what
they did and what happened in terms of, you know,
why many people think that the policy was two douvison
in the nineteen seventies has a lot to do whether
(26:12):
you think those measures of the output gap were reasonable,
and you know, the current estimates according to the Fed,
you know, are much less sort of dubvish than they
were at the time. But it highlights the fact that
even when you want to create a rule which is
sort of very technocratic and doesn't give you any wiggle room.
That's not entirely true, because something like the output gap
(26:34):
is not something that you can just read off a
statistic like inflation. Actually you can, and so as a consequence,
you know, it really matters what judgment you take about
where you are relative to the economy's potential.
Speaker 3 (26:46):
You can never escape human you never quite escape human judgment, unfortunately.
Speaker 2 (26:50):
I remember that the output gap debate was a big
thing after two thousand and eight as well. Okay, just
going back to the idea of this technocratic rule, whether
it's scriptive or descriptive, I know people have different opinions
on that, but supposedly one of the benefits of it
being possibly prescriptive was that you have a central bank
that like does a very expected thing, like you know
(27:13):
what the reaction function is and you know what they're
going to do in response to inflation. How does that
play into the credibility aspect, because on the other hand,
you know, more credible central banks, they can kind of
go off and do their own thing, go beyond the
tailor rule, as you put it in the paper. But
on the other hand, does that unexpected behavior perhaps have
an impact on their own credibility, even if it's successful
(27:35):
in the short term.
Speaker 4 (27:36):
Absolutely, I mean, I think that the technocratic rules, like
the tailor rule, they absolutely have a place in the
canon of monetary policy. And you know, perhaps one could
even argue that they should be the default in response
to many kinds of inflationary episodes, because there are many
kinds of inflationary episodes, like those associated with excessive demand,
(27:57):
you know, an overheating economy and all so even worse,
just sort of self fulfilling worries about inflation that spiral
off into really serious inflationary episodes. So in response to
all of those kinds of episodes, you know, it may
may be a very good idea for people to be
able to expect that central bank is going to respond
aggressively along the lines of something like the tailor rule.
(28:18):
And there's a sense in which you might want to
think about going beyond the tailor rule as something that
you don't do all the time, but that you recognize
has to happen some of the time when you have
a strong sense that a different kind of shock is
hitting the economy, and in some of those episodes, you
might actually want to very explicitly use forward guidance. So,
for example, during the Great Recession, that was a period
(28:40):
when there was you know, some of the most explicit
usage of forward guidance to talk about the timing of
how long the FED was going to keep interest rates
at zero, and that was a very powerful tool in
terms of affecting longer term interest rates. It's very easy
to see that in the data. And that's the kind
of thing where you know, it's not about going away
(29:02):
from reputation, which it's true. That core idea is that
you want markets to absolutely be confident that the central
bank is going to respond aggressively to any sense of
de anchoring of inflation expectations, and that is very important,
but at times you may want to use for guidance
in other ways, and the response of the fad to
(29:25):
the Great Recession as an example of that.
Speaker 3 (29:27):
I just have one last question, and it's kind of selfish.
So you're talking about, you know, different sources of inflation,
whether it's access demand or whether it's supply. Tracy and
I did like a ton of podcast episodes in twenty
twenty one twenty twenty two about supply chains. We talked
about the ports and all this stuff that you know,
but someone could say, you guys were missing the forest
(29:48):
for the trees. Distress at the ports wasn't about supply
Chaine was because there was too much demand. Distress at
the X factory was it because of some supply chain
or missing part. There was just too much demand. You
guys were just disguised ueeing demand problems by focusing on
choke points that are inevitably going to emerge when booming demand.
I still think about this. I'm like, oh, should we
have focused on you know, I'm like, but you have
(30:09):
described a lot of this inflation, and part of the
reason for the Meca disinflation is because a lot of
it was supply defense. You know, I'm looking for a
defense of all this focus that we did on the
supply side.
Speaker 4 (30:20):
So I think you're you're right that there's kind of
a false dichotomy between talking about demand shocks and things
like supply constraints, you know, like the ports and the
Suez Canal and so on, Because you're right that if
you have too much demand then at some point, you know,
these supply chains get clocked, and so it's it's it's
absolutely right that those kinds of supply constraints are not
(30:40):
quite the same as supply shocks, right, But there are
other things which are just directly shocked.
Speaker 3 (30:47):
The war in Ukraine was a shocked.
Speaker 4 (30:49):
Exactly, and COVID, for example, generated all sorts of sort
of negative productivity throughout the economy that just made things
more expensive to produce in a variety of ways. So
these are some of the things that I think are
genuinely basically negative productivity shocks, which were sort of hard
to find examples of previous to COVID, but easy to
(31:10):
find examples of during COVID.
Speaker 2 (31:13):
How could are policy makers at identifying types of shocks
in real time?
Speaker 4 (31:17):
That is a very important question. And you know, I
think my discussion of the nineteen seventies and the fact
that you know, views have changed over time about the
output gap during that period and also during the COVID inflation,
you know, views of change shows that this is by
no means perfect. But at the same time, I think
there are times when there's a strong sense that, you know,
(31:38):
the COVID inflation, for example, wasn't just about you know,
self fulfilling inflation expectations or something like this, And so
that's where I want to emphasize this idea that there's
a difference between saying that we can always identify the
shocks with confidence, which clearly we cannot, and saying that
we can never identify any shocks, you know, to the
(31:58):
extent that we need to tire ours all the time
to a mechanical rule, which you know, may deviate from
what theory really says is opt to a monetary policy.
But again, you know, I think crucial ideas is all
of this has to take place against the background where
there's sort of confidence in the central banks commitment to
longer run inflation stability.
Speaker 2 (32:17):
All right, Emmy Nakhimura, thank you so much. This was
a real treat for us. I kind of want to
go to Berkeley now.
Speaker 3 (32:22):
Yeah, I know it's a I did.
Speaker 1 (32:24):
So.
Speaker 3 (32:24):
That was amazing. Thank you so much. That was fantastic.
Speaker 2 (32:26):
Thank you. That was great. Joe, that was fantastic. I
really enjoyed that conversation. And Emmy has a remarkable way
of explaining like some complicated concepts, yeah, very simply and
(32:49):
in a real understandable way, because if you flip through
her paper, there's a lot of formulas and things like that.
So it looks complicated, but she explained it very.
Speaker 3 (32:57):
Clearly, incredibly clearly. I had the same thing. I was like, oh, man,
it would be so nice to just be like a
student and like alert, you know, get to a student.
Sounds very fun but incredibly clear. And you know, she's,
you know, one of the foremost inflation experts in sort
of academia. And so to hear her sort of like
(33:19):
sort of summation of how she thinks about the last
five years and the lessons learned from it was like
a real treat Yeah.
Speaker 2 (33:25):
And obviously there are a couple of takeaways there. So one,
it is incredibly hard for policy or often incredibly hard
for policy makers to identify shocks, you know, at the
moment that they're happening, but sometimes they can, like in
COVID And I guess the second takeaway is the importance
of credibility. Yeah, right, And if you manage to successfully
(33:48):
control inflation for years and years and decades or whatever,
you build up that social capital which then allows you
to be somewhat more flexible when you have another crisis.
Speaker 3 (33:59):
Yeah. I thought that was very interesting. Also, there are
a couple other things that's struck me. First of all,
until reading this paper. And this is just my fault
because I could look this up at any time. I
hadn't realized that the tailor rule was built up six
years of data. There's like, Okay, this is the rule
that describes when a central bank.
Speaker 2 (34:18):
Is a monetary policy.
Speaker 3 (34:20):
Basically, this is the rule that sort of describes what
a well functioning central bank looks like is basically six years.
You know. That's interesting. That's interesting to me too. And
second of all, this idea that even though it does
look like a hard rule, that you can't escape the
fact that you have to judge the output gap. And
there were very big debates about the size of the
(34:42):
output gap after two thousand and eight and two thousand
and nine, very sharp disagreements about the capacity or what
full employment looked like. So even that doesn't fully solve you.
Even if you do tie yourself to the lash of
a hard rule or lash yourself to the mast of
a hard rule, the tough problem.
Speaker 2 (34:56):
Still yeah, it's it's tough, all right, leave it there,
Let's leave it there. This has been another episode of
the Odd Lots podcast. I'm Tracy Alloway. You can follow
me at Tracy Alloway.
Speaker 3 (35:06):
And I'm Jill Wisenthal. You can follow me at the Stalwart.
If you want to read Emmy's paper, go check out
the Kansas City Fed's website. Follow our producers Kerman Rodriguez
at Kerman armand Dashel Bennett at Dashbot and Kilbrooks at Kilbrooks.
For more Oddlots content, go to Bloomberg dot com slash
odd Lots we're the daily newsletter and all of our episodes,
and you can chat about all of these topics twenty
(35:27):
four seven in our discord Discord dot gg slash out Lots.
Speaker 2 (35:32):
And if you enjoy odd Lots, if you like it
when we go to Jackson Hole to interview prominent economists,
then please leave us a positive review on your favorite
podcast platform. And remember, if you are a Bloomberg subscriber,
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All you need to do is find the Bloomberg channel
on Apple Podcasts and follow the instructions there. Thanks for
(35:53):
listening in
Bloomberg Audio Studios, Podcasts, Radio News.
Speaker 2 (00:18):
Hello and welcome to another episode of the Authoughts podcast.
I'm Tracy Alloway.
Speaker 3 (00:22):
And I'm Joe. Why isn't thal Joe?
Speaker 2 (00:23):
We're back in Jackson Hall.
Speaker 3 (00:25):
Jackson Hall. I love it here.
Speaker 2 (00:26):
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.
Speaker 3 (00:34):
There's so much going on right now. To see the least,
we don't need to recapituate. 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.
Speaker 2 (00:44):
I love how you say there's no need to recapitulate
and then you immediately do it.
Speaker 3 (00:48):
Well, there's just so much going on.
Speaker 2 (00:49):
I think you're hitting on like a couple 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, like 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
(01:11):
talk about. And there's obviously the direction of short term
interest rates.
Speaker 3 (01:15):
And then of course the formal and then of course
the formal theme of the conference about labor, labor markets
and all this stuff. So yes, many different things.
Speaker 2 (01:22):
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 Jehan.
Speaker 3 (01:35):
We've wanted to talk to for a long time.
Speaker 2 (01:37):
Absolutely, we're going to be speaking with Emmy Nakamura, a
professor at Berkeley and the author of a paper being
presented at Jackson Hole called Beyond the Tailor Rule. So, Emmy,
thank you so much for coming on all lots, it's
great to be here. Let's just start what is the.
Speaker 3 (01:51):
Tailor rule before we can go beyond it?
Speaker 4 (01:53):
Yeah, yeah, Well, in nineteen ninety three, 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
(02:15):
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 nineteen ninety three, the
tailor rule has achieved more or less mythical status within
economics and the policymaking world. The original paper was mostly descriptive.
(02:36):
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 tailor rule, they're often asked to explain
why this was a major theme in the post COVID
inflation for example.
Speaker 2 (02:57):
So on that note, could I ask why the tale
rules specifically and talk to us maybe about the process
of how these papers come into being a head of
Jackson hole.
Speaker 4 (03:07):
Why we wrote about the tailor rule. Well, as I said,
the tailor rule has achieved this incredibly dominant status within
not only the academic literature and monetari policy, but also
within the policy community. And yet when I teach students,
one of the things that's somewhat uncomfortable is that the
tailor rule doesn't fit all that well over the past
(03:29):
twenty years. So it fit pretty well during the Greenspan
period and all the way until about two thousand and
eight 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 lift off from zero interest rates.
So given that twenty years is starting to be a
(03:50):
long time, the question is should we still view this
as the benchmark for describing monetari policy. And then there's
this second question about how to think about Goodmane type 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 nineteen
(04:11):
eighty seven to nineteen ninety two, 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 guiy to good mone type policy too,
And 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.
Speaker 3 (04:30):
But this is funny, right, like, 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,
Taylor Roll says it should be a lot higher, or
the tailor it should be lower. Whatever.
Speaker 2 (04:41):
We just heard it from Jeff Schmidt the Kansas Fed, right.
Speaker 3 (04:44):
And yet this is all based on basically a sort
of backing out description of five years of monetary policy
that six years, six years? Okay, sorry, six year maybe
not quite So can you talk a little bit more
about though this. I don't know if it's a debate
or like, how people think about prescriptive versus descriptive within
this role.
Speaker 4 (05:04):
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 MONTEI policy should
do in terms of leaning against inflation, leaning against an overheating.
Overheating economy can end up becoming maybe more than even
(05:29):
the author intended as a prescriptive rule. And 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 nineteen ninety three. This was
a period when the FED was coming off some very
difficult years for monetoi policy. So the nineteen seventies and
nineteen eighties were very difficult years for monte policy. Inflation
(05:50):
had been very high in the late nineteen seventies and
early nineteen eighties. 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
(06:12):
have those kinds of reputational challenges, sometimes you kind of
need to tie yourself to a mask and say we
are not going to.
Speaker 3 (06:18):
Go to a mathematical rule exactly.
Speaker 4 (06:20):
Because the nineteen seventies 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 you know, several decades later, the Fed's
(06:44):
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. 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
(07:06):
we saw after COVID. And so this is the sense
in which I think, you know, this is a time
at which we want to ask these questions.
Speaker 2 (07:12):
It reminds me very much of the Psalm rule and
the arguments there that if you find like a specific number,
the ideas 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 tailor rule is
that it suggests rates need to rise by more than
one for one with inflation to properly offset inflation, like
(07:34):
you have to go in very very strong. But you
found in your paper that that's not always the case exactly.
Speaker 4 (07:40):
So even beyond the idea that you want to raise
interest rates more than one for one, so it's the
coevision's one point five in the tailor rule. But there's
the idea even beyond that of the tailor 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. And if you
want to raise real interest rates, then you have to
is nominal interest rates more than one for one, exactly
(08:02):
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 tailor rule prescription and what central banks
actually did during the COVID inflation was so large. And
actually for the United States this gap was about it
was over ten 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
(08:25):
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. So when inflation is
coming from an overheating economy, then there's this notion in
monetary economics that you can satisfy all objectives of both
(08:47):
kind of calming down the economy but also keeping inflation
in check by raising interest rates pretty aggressively and actually
optal monetary policy theory implies you might even want to
be more aggressive than the tailor rule. But in contrast,
when you have shot to inflation that don't come directly
from an overheating economy but also come from you know,
other sources of increases in costs, you know, so the
(09:08):
supply shocks that people talked about during the COVID inflation period,
then these same models can imply very different predictions. They
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
(09:31):
monetary policy is actually exactly optimal, so the centerflike is
really doing the right thing, and then we run regressions,
you know, where we try to estimate what we get
for the tailor role 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.
Sometimes it's close to zero, sometimes it's even negative. So
really a lot of things can happen when you deviate
(09:53):
only from this view of inflation is coming from an
overheating economy.
Speaker 3 (10:12):
Did the FED do a good job?
Speaker 2 (10:14):
The paper reads like vindication.
Speaker 3 (10:16):
Yeah, because I think in twenty twenty five there's still
plenty of fights about this question, what's your fake?
Speaker 4 (10:21):
I think in so we don't know what's going to happen. Yeah,
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 flak for
(10:44):
saying that inflation was going to be very transitory when
inflation was significantly more persistent. That said, inflation did come
down very quickly, and there hasn't been a recession, and
that is remarkable. Not only has there not been a recession,
and not only didn't place and come down very quickly,
but longer term inflation expectations really did not become unhinged.
(11:04):
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
at amount of history, this is going.
Speaker 3 (11:20):
To look like a big success.
Speaker 2 (11:22):
So this is where central bank independence and credibility actually
comes into play when it comes to those longer term
inflation expectations. How did you actually measure credibility in this paper?
Because you don't look just at the FED, you look
at a bunch of other.
Speaker 4 (11:37):
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
(12:02):
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. And these are the countries
we refer to in our paper as late risers because
they were late to the game right. But there were
other countries in the world we referred to as early
risers who raised interest rates a lot more aggressively and
(12:25):
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 relate 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. So
the early risers did respond very aggressively the COVID inflation,
(12:47):
but they actually saw inflation rise by a lot more
during this episode. So then we asked the question, well,
what could explain that seems sort of backwards? You know,
you have these countries that seemed to have responded very
aggressively with interest rates and yet they saw the large
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,
(13:11):
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. And so we
look at average inflation over the previous three decades, and
we see that the early riser countries, the ones that
you know probably felt they had to respond ery aggressively
to the COVID inflation, also had much more checkered inflation histories.
(13:35):
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
(13:56):
that they had the kind of strongly anchored inflation expectations
that these countries could benefit from. And so for these countries,
it really probably was not an option to think that
they could look through 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.
Speaker 3 (14:16):
So I find this to be really fascinating. I want
to get to the question of like whether the develop
market or the US is like ground down its stock
of credibility over the last five years, But I wanted
to 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
(14:36):
of mediocre history of controlling inflation this time around were
really on the ball in unison. I 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.
Like how consistent is this process around the world, whereby
(14:59):
the countries that have a track record were early risers
this time.
Speaker 4 (15:02):
Around, right, So we're not including every country, So there
are some countries which are outliers in terms of their
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. So back in the nineteen seventies and
(15:22):
nineteen eighties, 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
(15:43):
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, yeah, and you know,
and there's just sort of starting to be able to
get over it. And then the question is do you
think that the public will be willing to watch you
go through a period of say, ten percent inflation and say, oh,
we're sure you're going to get it back to two percent,
(16:05):
or do you think you know, there's going to be
real question of whether you're going to be able to
achieve that.
Speaker 2 (16:09):
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 you know, maybe another central bank that doesn't have
that credibility walk us through what exactly are the benefits
(16:29):
of not having to do.
Speaker 4 (16:31):
That, of not having to raise race rise Absolutely well,
you get closer to optimal monetary policy. So in the models,
you know, 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
(16:52):
a shock like during COVID to people's demand for goods
versus services. If you raise the interest rate dramatically, like
the tailor rum might have predicted you, it is interesting
to ten percent. So what's going to have to happen
to get inflation down to zero in the short run. Well,
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.
Speaker 2 (17:11):
You know, Trump will tweet at you more or post
on truth social more.
Speaker 4 (17:14):
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
(17:35):
be more transitory than it actually was. But 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 has going to take
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 you know, some of these
shocks are going to dissipate. And then I guess the
(17:57):
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 a forward guidance.
So this is one of the big innovations in monetary
policy over recent decades. We think about forward guidance a
lot in the context of the zero lower bound, when
you can't do anything with FED funds rate, and so
(18:19):
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 it shots about what it's going
to do with interest rates, even over the next year.
So this was hugely important during the COVID inflation research,
because the FED started talking about raising interest rates and
(18:40):
a longer term bond yield started rising pretty rapidly in
late twenty twenty one, substantially before the FED funds rate
actually started to rise rapidly. And 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
an impact on the bond market. Through that channel, we'll
(19:02):
actually want to use both. And so that's another advantage
of not being bound by these kinds of constraints.
Speaker 3 (19:07):
The strikes me is an incredibly important point, which is
that you can tighten monetary policy by talking, by saying,
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're
already indicated and you're pulling forward those raid hikes. So
(19:28):
do we have less credibility today?
Speaker 4 (19:30):
You know?
Speaker 3 (19:30):
So, Okay, 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
(19:50):
be more of an early riser than it felt in
this cycle.
Speaker 4 (19:53):
I would think almost definitely yes. Remember that going into
the COVID inflation, you know, regular pe hadn't seen significant
amounts of inflation for years. It just wasn't really part
of the mindset of anyone. You know, when you saw,
for example, unions, in wage negotiations or other contexts things
(20:14):
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
(20:37):
of work to just explain the difference, for example, between
a nominal interest rate and a real interest.
Speaker 2 (20:41):
I did not earn interest on my bank account for
most of my adult life, so.
Speaker 4 (20:46):
I see exactly. But in contrast, for Latin American students,
they get in 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
(21:06):
see inflation again, it's going to be, you know, 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 you know, two inflationary episodes in the
recent past, whether this is sort of the new normal.
You know. I think it's important not to forget how
hard one those expectations of low inflation were for the
(21:29):
Federal Reserve in many other countries. You know, it's certainly
something that can dissipate.
Speaker 2 (21:35):
So, because we're dealing with the tailor 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
(21:57):
have different effects on the output gap. What type of
shock would tariffs be? I know this isn't the subject
of your paper, but you know your gut instinct, how
would you describe tariffs in terms of that economic shock
and the impact on output?
Speaker 4 (22:10):
So there have been a number of recent academic papers
on this. It's not the focus of our paper, but
I think that the overall message of those papers is
that you do want to look through sort of the
initial impact of the tariffs, but you don't want to
look through sort of second round effects. So to the
extent that you start to see an effect in terms
of longer run inflation expectations becoming unhinged and so on,
(22:33):
that's the part of the inflation that the central bank
would want to be responding aggressively to.
Speaker 3 (22:53):
I have another question that maybe outside the scope of
this specific paper, but.
Speaker 2 (22:58):
It has a lot of relevance to today.
Speaker 3 (23:00):
There's a lot when you think about around the world,
some central banks have more credibility than some others. Is
it that the good central banks just had like smarter,
better economists, advising them better on policy than the other ones.
Or does it have more to do with the political
conditions that allow a central bank to operate separately from
(23:22):
to essentially operate with independent agency, And is that more
of a thing that originates in the political sphere of
those countries.
Speaker 4 (23:28):
I think clearly the politics is very important. I guess
it would point to two things. One is those difficult
decades of the nineteen seventies and nineteen eighties which occurred
in many countries around the world, and where people in
these countries realized how much they hated inflation. We got
a little bit of a taste of this during the
COVID inflation. Inflation just is incredibly unpopular. And it was
(23:54):
for this reason that it was possible in the United
States to appoint Paul Wolker as chairman of the thing,
even though it was known before he was appointed what
he was going to do, that he was going to
raise interest rates aggressively, that this was going to be painful,
And so that's a remarkable thing that it was actually
possible to make this appointment. But of course similar things
actually happened in other countries as well. There were similar
(24:17):
appointments of aggressive, you know, central bankers that controlled inflation.
So I think part of this did come out of,
you know, sort of a public reaction to inflation. But
at the same time, it didn't happen everywhere, just like
you said, and could only have been in the context
of political protection for the central central bank independence and
(24:38):
perhaps in some ways it's just sort of a remarkable
thing that it ever did happen, that we've seen this
long period of low inflation in many of these countries.
Speaker 3 (24:45):
I something realized I've heard over the years at various
times where we're deviations from the Taylor rule, whether it
was the zero lower boundar era or it couldn't lower them,
or more recently, how far were they off in the
seventies when inflation was going crazy? There is there a
good measure of like, no, clearly they should have been higher.
This like, what does the tailor rules say about that?
Speaker 4 (25:07):
The nineteen seventies very interesting because one of the things
we point out in our paper is that the predictions
and the prescriptions of the Tailor rule are of course
only as good as the inputs you put into them.
And one of the things that some of the academic
literatures pointed out is that you don't necessarily want to
use the data that we have today on something like
the output gap, because views about the output gap, that is,
(25:30):
you know, how overheating is the economy have changed over time,
and in particular, in the nineteen seventies, the Federal Reserve
was pretty optimistic about the potential output of the US economy,
and for that reason, its judgment about the output gap
was pretty negative. And this helps to explain, through the
lens of the tailor rule, why they had pretty dubvish
(25:51):
monetary policy in the nineteen seventies. So actually, if you
take the real time data on what the FED said
it thought the output gap was at the time I'm
along with inflation, then you get more or less what
they did and what happened in terms of, you know,
why many people think that the policy was two douvison
in the nineteen seventies has a lot to do whether
(26:12):
you think those measures of the output gap were reasonable,
and you know, the current estimates according to the Fed,
you know, are much less sort of dubvish than they
were at the time. But it highlights the fact that
even when you want to create a rule which is
sort of very technocratic and doesn't give you any wiggle room.
That's not entirely true, because something like the output gap
(26:34):
is not something that you can just read off a
statistic like inflation. Actually you can, and so as a consequence,
you know, it really matters what judgment you take about
where you are relative to the economy's potential.
Speaker 3 (26:46):
You can never escape human you never quite escape human judgment, unfortunately.
Speaker 2 (26:50):
I remember that the output gap debate was a big
thing after two thousand and eight as well. Okay, just
going back to the idea of this technocratic rule, whether
it's scriptive or descriptive, I know people have different opinions
on that, but supposedly one of the benefits of it
being possibly prescriptive was that you have a central bank
that like does a very expected thing, like you know
(27:13):
what the reaction function is and you know what they're
going to do in response to inflation. How does that
play into the credibility aspect, because on the other hand,
you know, more credible central banks, they can kind of
go off and do their own thing, go beyond the
tailor rule, as you put it in the paper. But
on the other hand, does that unexpected behavior perhaps have
an impact on their own credibility, even if it's successful
(27:35):
in the short term.
Speaker 4 (27:36):
Absolutely, I mean, I think that the technocratic rules, like
the tailor rule, they absolutely have a place in the
canon of monetary policy. And you know, perhaps one could
even argue that they should be the default in response
to many kinds of inflationary episodes, because there are many
kinds of inflationary episodes, like those associated with excessive demand,
(27:57):
you know, an overheating economy and all so even worse,
just sort of self fulfilling worries about inflation that spiral
off into really serious inflationary episodes. So in response to
all of those kinds of episodes, you know, it may
may be a very good idea for people to be
able to expect that central bank is going to respond
aggressively along the lines of something like the tailor rule.
(28:18):
And there's a sense in which you might want to
think about going beyond the tailor rule as something that
you don't do all the time, but that you recognize
has to happen some of the time when you have
a strong sense that a different kind of shock is
hitting the economy, and in some of those episodes, you
might actually want to very explicitly use forward guidance. So,
for example, during the Great Recession, that was a period
(28:40):
when there was you know, some of the most explicit
usage of forward guidance to talk about the timing of
how long the FED was going to keep interest rates
at zero, and that was a very powerful tool in
terms of affecting longer term interest rates. It's very easy
to see that in the data. And that's the kind
of thing where you know, it's not about going away
(29:02):
from reputation, which it's true. That core idea is that
you want markets to absolutely be confident that the central
bank is going to respond aggressively to any sense of
de anchoring of inflation expectations, and that is very important,
but at times you may want to use for guidance
in other ways, and the response of the fad to
(29:25):
the Great Recession as an example of that.
Speaker 3 (29:27):
I just have one last question, and it's kind of selfish.
So you're talking about, you know, different sources of inflation,
whether it's access demand or whether it's supply. Tracy and
I did like a ton of podcast episodes in twenty
twenty one twenty twenty two about supply chains. We talked
about the ports and all this stuff that you know,
but someone could say, you guys were missing the forest
(29:48):
for the trees. Distress at the ports wasn't about supply
Chaine was because there was too much demand. Distress at
the X factory was it because of some supply chain
or missing part. There was just too much demand. You
guys were just disguised ueeing demand problems by focusing on
choke points that are inevitably going to emerge when booming demand.
I still think about this. I'm like, oh, should we
have focused on you know, I'm like, but you have
(30:09):
described a lot of this inflation, and part of the
reason for the Meca disinflation is because a lot of
it was supply defense. You know, I'm looking for a
defense of all this focus that we did on the
supply side.
Speaker 4 (30:20):
So I think you're you're right that there's kind of
a false dichotomy between talking about demand shocks and things
like supply constraints, you know, like the ports and the
Suez Canal and so on, Because you're right that if
you have too much demand then at some point, you know,
these supply chains get clocked, and so it's it's it's
absolutely right that those kinds of supply constraints are not
(30:40):
quite the same as supply shocks, right, But there are
other things which are just directly shocked.
Speaker 3 (30:47):
The war in Ukraine was a shocked.
Speaker 4 (30:49):
Exactly, and COVID, for example, generated all sorts of sort
of negative productivity throughout the economy that just made things
more expensive to produce in a variety of ways. So
these are some of the things that I think are
genuinely basically negative productivity shocks, which were sort of hard
to find examples of previous to COVID, but easy to
(31:10):
find examples of during COVID.
Speaker 2 (31:13):
How could are policy makers at identifying types of shocks
in real time?
Speaker 4 (31:17):
That is a very important question. And you know, I
think my discussion of the nineteen seventies and the fact
that you know, views have changed over time about the
output gap during that period and also during the COVID inflation,
you know, views of change shows that this is by
no means perfect. But at the same time, I think
there are times when there's a strong sense that, you know,
(31:38):
the COVID inflation, for example, wasn't just about you know,
self fulfilling inflation expectations or something like this, And so
that's where I want to emphasize this idea that there's
a difference between saying that we can always identify the
shocks with confidence, which clearly we cannot, and saying that
we can never identify any shocks, you know, to the
(31:58):
extent that we need to tire ours all the time
to a mechanical rule, which you know, may deviate from
what theory really says is opt to a monetary policy.
But again, you know, I think crucial ideas is all
of this has to take place against the background where
there's sort of confidence in the central banks commitment to
longer run inflation stability.
Speaker 2 (32:17):
All right, Emmy Nakhimura, thank you so much. This was
a real treat for us. I kind of want to
go to Berkeley now.
Speaker 3 (32:22):
Yeah, I know it's a I did.
Speaker 1 (32:24):
So.
Speaker 3 (32:24):
That was amazing. Thank you so much. That was fantastic.
Speaker 2 (32:26):
Thank you. That was great. Joe, that was fantastic. I
really enjoyed that conversation. And Emmy has a remarkable way
of explaining like some complicated concepts, yeah, very simply and
(32:49):
in a real understandable way, because if you flip through
her paper, there's a lot of formulas and things like that.
So it looks complicated, but she explained it very.
Speaker 3 (32:57):
Clearly, incredibly clearly. I had the same thing. I was like, oh, man,
it would be so nice to just be like a
student and like alert, you know, get to a student.
Sounds very fun but incredibly clear. And you know, she's,
you know, one of the foremost inflation experts in sort
of academia. And so to hear her sort of like
(33:19):
sort of summation of how she thinks about the last
five years and the lessons learned from it was like
a real treat Yeah.
Speaker 2 (33:25):
And obviously there are a couple of takeaways there. So one,
it is incredibly hard for policy or often incredibly hard
for policy makers to identify shocks, you know, at the
moment that they're happening, but sometimes they can, like in
COVID And I guess the second takeaway is the importance
of credibility. Yeah, right, And if you manage to successfully
(33:48):
control inflation for years and years and decades or whatever,
you build up that social capital which then allows you
to be somewhat more flexible when you have another crisis.
Speaker 3 (33:59):
Yeah. I thought that was very interesting. Also, there are
a couple other things that's struck me. First of all,
until reading this paper. And this is just my fault
because I could look this up at any time. I
hadn't realized that the tailor rule was built up six
years of data. There's like, Okay, this is the rule
that describes when a central bank.
Speaker 2 (34:18):
Is a monetary policy.
Speaker 3 (34:20):
Basically, this is the rule that sort of describes what
a well functioning central bank looks like is basically six years.
You know. That's interesting. That's interesting to me too. And
second of all, this idea that even though it does
look like a hard rule, that you can't escape the
fact that you have to judge the output gap. And
there were very big debates about the size of the
(34:42):
output gap after two thousand and eight and two thousand
and nine, very sharp disagreements about the capacity or what
full employment looked like. So even that doesn't fully solve you.
Even if you do tie yourself to the lash of
a hard rule or lash yourself to the mast of
a hard rule, the tough problem.
Speaker 2 (34:56):
Still yeah, it's it's tough, all right, leave it there,
Let's leave it there. This has been another episode of
the Odd Lots podcast. I'm Tracy Alloway. You can follow
me at Tracy Alloway.
Speaker 3 (35:06):
And I'm Jill Wisenthal. You can follow me at the Stalwart.
If you want to read Emmy's paper, go check out
the Kansas City Fed's website. Follow our producers Kerman Rodriguez
at Kerman armand Dashel Bennett at Dashbot and Kilbrooks at Kilbrooks.
For more Oddlots content, go to Bloomberg dot com slash
odd Lots we're the daily newsletter and all of our episodes,
and you can chat about all of these topics twenty
(35:27):
four seven in our discord Discord dot gg slash out Lots.
Speaker 2 (35:32):
And if you enjoy odd Lots, if you like it
when we go to Jackson Hole to interview prominent economists,
then please leave us a positive review on your favorite
podcast platform. And remember, if you are a Bloomberg subscriber,
you can listen to all of our episodes absolutely ad free.
All you need to do is find the Bloomberg channel
on Apple Podcasts and follow the instructions there. Thanks for
(35:53):
listening in
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