Comments on Athanasios Orphanides’ The Quest For Prosperity Without

Inflation

John B. Taylor

Stanford University

January 8, 2000

Overview• “Instant replay” of monetary policy decisions

– from the start of the Great Inflation through 1993.

• Postulates what information was available and was used to make the decisions – Definition of “real time” data

• Calls attention to the problems with historical studies that simply use current data to evaluate past policy decisions. – Clarida, Gali, Gertler, Judd, Rudebusch, Taylor

• Dramatizes the uncertainty about potential GDP– Also about deviations of actual GDP from potential.

• Criticizes monetary policy rules with the level rather than the change in such deviations.

Constructive criticism

• Pointing out the implications of uncertainty in measuring potential GDP is useful and welcome. – an issue about which we are all aware

• it is why there is so much research on estimating potential

– Historical charts are wonderful.

• However, the measure of uncertainty is – flawed conceptually, – exaggerated in magnitude– overemphasized in comparison with other problems

• One is left with serious doubts about the message.

The key assumption

• Historical decisions with a monetary policy rule require old, un-revised data on inflation, real GDP and potential GDP – no problem for real GDP or inflation– But there is a problem about potential:

• no record of a potential series produced at the Fed in 1960s and 1970s

• Answer to the problem? – Assume that the Fed used the series produced by the

White House– Analogous to assuming a can opener

Reasons to question the assumption and thus the conclusion

• Potential GDP and its growth rate became politicized as early as the late 1960s

• Serious economic analysts—like Burns and Greenspan—paid no attention to it

• The series shows a GDP gap of 15 percent in the mid 1970s—comparable to the Great Depression!

• Economists knew that the revision in 1977 was still too small.– Even though paper claims that “this could not have been know in

1997.” – Done by a lame-duck CEA that still pulled back from staff estimates

(e.g.. 4.9 percent u*)

• Concept of potential GDP was a max not a mean

Reasons to worry about reacting to y only rather than to y

• Overshooting:– Policy is too easy when economy is way above capacity and growing

at potential growth rate

• Undershooting:– Policy is too tight when economy is below capacity and growing at

potential growth rate

• Econometric model-based evidence:– Rudebusch (1999): modern forward/backward looking model (with

estimates of uncertainty in potential)– Taylor (1985) VAR type model

• Also worry about loaded words: – “prudent” versus “active,” with cites to Friedman Meltzer

Maybe not so prudent recently (using real time data (Fig 20))

0

2

4

6

8

10

90:3 91:1 91:3 92:1 92:3 93:1 93:3 94:1

\Federal Funds Rate

Taylor Rule \

GDP Growth Rate Rule /

Percent

Residuals as Mistakes• Deviations from policy rules cannot be blindly interpreted

as mistakes: some discretion is needed.• Clearly the inflationary policy in the late 1960s and 1970s

was a mistake.• But the response to the 1987 stock market crash was not a

mistake.• What about the high interest rates at the end of the great

disinflation that were a deviation from a policy rule?– Strongly disagree with the following unqualified statement:

“This ‘mistake,’ Taylor concludes, accounts for the dismal performance of output in the early 1980s and the depth of the 1982 recession.”

Conclusion

• Uncertainty in measuring potential is a problem• Down weight output deviations: Rudebusch, Smets

• 0.5 is already pretty low, but perhaps it could be lower

• 0.0 seems too low

• 1.0 seems too high

• Spend a lot of time researching productivity growth and unemployment measures– Look at other variables, such as capacity utilization or

unemployment, that help estimate the GDP deviations