Emi Nakamura on Central Bank Credibility and the Taylor Rule

SPEAKER_2 (0:02)

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Tracy Alloway (0:18)

Hello, and welcome to another episode of the Odd Lots Podcast. I'm Tracy Alloway.

Joe Weisenthal (0:22)

And I'm Joe Weisenthal.

Tracy Alloway (0:23)

Joe, we're back. And Jackson Hole.

Joe Weisenthal (0:25)

Jackson Hole, I love it here.

Tracy Alloway (0:26)

I love it here. It's beautiful. It's beautiful. And not only do we get a chance to enjoy the gorgeous scenery, we get a chance to talk economic policy.

Joe Weisenthal (0:34)

There's so much going on right now. To say the least, we don't need to recapitulate. Everyone knows what's going on right now. There's so much stuff, whether we're talking about macro situation, whether we're talking about whatever.

Tracy Alloway (0:44)

I love how you say there's no need to recapitulate, and then you immediately do it.

Joe Weisenthal (0:48)

There's just so much going on.

Tracy Alloway (0:49)

I think you're hitting on a couple of things, which is there are these different themes floating through the conference. Obviously, you have uncertainty over what tariffs actually do to the economy. What type of shock are they? Do they destroy demand and therefore maybe cause deflation, or do they lead to companies passing on those costs and cause inflation? There's central bank independence, which everyone wants to talk about, and there's obviously the direction of short-term interest rates.

Joe Weisenthal (1:17)

And then of course, the formal theme of the conference about labor markets and all this stuff. So yes, many different things going on.

Tracy Alloway (1:23)

All right. Well, I am very pleased to say that there is in fact one paper that ties basically all these themes together. So we have the author here, and really the perfect guest to talk to.

Joe Weisenthal (1:35)

Someone we've wanted to talk to for a long time.

Tracy Alloway (1:36)

Absolutely. We're going to be speaking with Emi Nakamura, a professor at Berkeley, and the author of a paper being presented at Jackson Hole called Beyond the Taylor Rule. So Emi, thank you so much for coming on Odd Lots.

Emi Nakamura (1:49)

It's great to be here.

Tracy Alloway (1:50)

Let's just start. What is the Taylor Rule?

Joe Weisenthal (1:52)

Before we can go beyond it.

Tracy Alloway (1:53)

Yeah.

Emi Nakamura (1:54)

Well, in 1993, John Taylor wrote a paper in which he showed that the behavior of the Federal Reserve could be described by this remarkably simple rule as a function of inflation and what people call the output gap, which is sort of a measure of how overheated the economy is. And this was very surprising to people because people typically think of what the Federal Reserve and other central banks do as incredibly complicated. And so the surprise was that you could actually describe it by something very simple. And since that time when John Taylor wrote his original paper in 1993, the Taylor Rule has achieved more or less mythical status within economics and the policymaking world. The original paper was mostly descriptive. Like I said, it was pointing out that the behavior of the Fed, which seemed complicated, could actually be described by something really simple. But since then, it's really become a guide for prescriptive monetary policy. And when central banks deviate from the Taylor Rule, they're often asked to explain why this was a major theme in the post-COVID inflation, for example.

Tracy Alloway (2:57)

So on that note, could I ask why the Taylor Rule specifically? And talk to us maybe about the process of how these papers come into being ahead of Jackson Hole.

Emi Nakamura (3:07)

Why we wrote about the Taylor Rule? Well, as I said, the Taylor Rule has achieved this incredibly dominant status within not only the academic literature on monetary policy, but also within the policy community. And yet, when I teach students, one of the things that's somewhat uncomfortable is that the Taylor Rule doesn't fit all that well over the past 20 years. So, it fit pretty well during the green span period and all the way until about 2008 in the United States. But it hasn't fit very well since then. First of all, there was the zero lower bound period when interest rates were just at zero. But it also didn't predict very well either the timing or the magnitude of the lift off from zero interest rates. So, given that 20 years is starting to be a long time, the question is, should we still view this as the benchmark for describing monetary policy? And then there's the second question about how to think about good monetary policy. So when John Taylor wrote his original paper, it was mostly descriptive paper, but he did point out that this was a time period. The time period he said was actually only six years. It was from 1987 to 1992 But he pointed out that this was a time period a lot of people thought of as representing good monetary policy. So while the paper was mostly descriptive, he did say, well, maybe this is a guide to good monetary 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 re-investigate that theme.