By Michael S. Derby
Stanford University professor John Taylor, a contender to become the next Federal Reserve chairman, has repeatedly criticized the central bank by saying it held interest rates too low before and after the financial crisis.
But how much higher should rates have been? Quite a bit, according to estimates by economists applying his eponymous "Taylor rule," a mathematical formula for setting rates based on several economic variables.
While there are multiple versions of the rule, the classic 1993 model indicates the Fed's benchmark federal-funds rate should have started rising sooner and more in the years before the crisis, dipped below zero during the worst of the recession, and started rising in late 2009, according to a tool offered by the Atlanta Fed.
In contrast, the Fed held the fed-funds rate near zero from late 2008 until late 2015, and has raised it little since then.
Under the Taylor rule, the rate would be between 2.5% and 3% now, more than a percentage point higher than where the Fed has it, in a range between 1% and 1.25%.
Speaking at a Boston Fed conference last week, Mr. Taylor repeated his argument in favor of basing Fed interest-rate policy on established rules, something that some Republican lawmakers have pushed for. He said he created his rule to provide "something relatively simple that would not create shocks and could react to shocks well." He believes that until around 2003, the rule described pretty well how the Fed actually set policy.
Mr. Taylor could be in a position to try to apply his rule next year. President Donald Trump met with the economist earlier this month to discuss the top Fed job.
Mr. Trump met Thursday with Fed Chairwoman Janet Yellen and has said he is considering nominating her to stay in the job when her term as chief expires in February. He also is considering and has met with Fed governor Jerome Powell and former Fed governor Kevin Warsh. The president's top economic adviser Gary Cohn is also a candidate. A White House official said the president is expected to announce his decision before a trip to Asia that begins Nov. 3.
Fed officials see value in Mr. Taylor's rules as a way to help them think about policy. But they also believe the value is limited. Officials such as New York Fed President William Dudley have long argued rules don't take account of financial conditions, which are a critical driver of the economy's performance.
Boston Fed President Eric Rosengren at the conference last week argued against requiring the Fed to follow a formal rule. Mr. Rosengren pointed to an example of when the Taylor rule would have led the central bank astray. "In 2007, the actual federal-funds rate decreased much sooner than would have been implied by the 1993 Taylor rule," he said. "In the case of 2007, a much slower reaction to the impending financial problems would have exacerbated what was already a very serious economic downturn."
One of the Fed's biggest supporters of keeping rates low, Minneapolis Fed leader Neel Kashkari, has reckoned following the Taylor rule over recent years would have been a disaster. He said his bank estimates that following the rule would have meant 2.5 million fewer jobs created during the recovery.
The Taylor rule also would prescribe a higher fed-funds rate now, despite persistently weak inflation. Several Fed officials have said in recent months they won't support another rate increase until they see evidence that inflation is rising toward their 2% target.
San Francisco Fed President John Williams said recently he expects the central bank to raise the fed-funds rate over the next two years to a long-term level of 2.5%. That would be lower than what the Taylor rule prescribes now.
Mr. Taylor could have a hard time trying to implement his rule if he becomes chairman, given the strong consensus among Fed officials in favor of their current policy.
"Presumably if most people disagreed with -- I'm not anticipating this -- but if most people disagreed with a chair, you could have a possibility that the chair would lose the vote," Mr. Eric Rosengren said in an interview. "A rational chair" who doesn't want that sort of setback would then change tack and move to better reflect his colleagues' views, he said.
Write to Michael S. Derby at [email protected]