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posted on 19 June 2016

The Vanity Of Central Bankers And The Common Sense Rule

by Danielle DiMartino Booth, Money Strong

Money Strong Article of the Week

Some wedding gifts just keep on giving, even after the celebrated union upon which they were bestowed has failed. That would certainly be true in the case of Carly Simon and James Taylor, whose notoriously rocky marriage ended in 1983.

The timing of her November 1972 wedding marked more than a vow to Taylor, it coincided with Simon's gift to pop music and the release of "You're So Vain," which ripped to the No. 1 spot on the charts and still retains the ranking of 82nd highest on Billboard's Greatest Songs of All-Time. What a generous gift!

But, was it for the duo? Might it just be possible this lasting gift bred some not so blissful turbulence in the marriage? At the time, speculation swirled around the obviously vainglorious but mystery male subject. Was it Warren Beatty, David Geffen, Mick Jagger, Kris Kristofferson, Cat Stephens or James Taylor himself? The list went on and on. As of November 2015, Simon has only divulged that Beatty was one of three the lyrics reference. Taylor is not among the remaining two mystery men.

It's a safe bet that a Taylor of a completely different stripe is far from being a mystery man in Janet Yellen's appreciably less torrid past. In fact, the roles might even be reversed in Yellen's world, with a slew of economists lamenting her vanity in rejecting them. The eminent John Taylor would be first in line, given that no less than his namesake rule used for devising monetary policy has been so explicitly and publically snubbed by the Chair.

The Taylor rule debuted in 1993 and continues to grow in its appeal thanks to the simplicity with which it can be executed. Though Taylor engaged the mandatory calculus to build his model, the inputs are elegant in their straightforward real world ease of application. At the risk of being overly simplistic, the Fed should set interest rates based on targeted vs actual employment and inflation levels; an ideal interest rate is consistent with full employment which is theoretically in sync with potential economic output.

If inflation is above target or if the economy is running too hot, as in above potential, the Fed should raise rates. If inflation is too low or economic growth too slow, well then the Fed should lower rates to encourage growth. In a perfect world, inflation and economic output are neither too hot nor too cold. That just right Goldilocks place in the ether calls for a 'neutral' interest rate of two percent, where the fed funds rate has historically hovered.

Here, the situation becomes perplexing in that it is the very simplicity of the rule which renders it an abomination to the reigning elite. Their preference since the crisis broke has been to embrace overly complicated models and deploy obfuscation to drive interest rates to the zero bound and beyond with blind abandon.

To add insult to injury, Yellen herself has conceded that the Taylor rule has long since signaled rates were too low. This is what she had to say in a March 2015 speech:

"Even with core inflation running below the Committee's 2 percent objective, Taylor's rule now calls for the federal funds rate to be well above zero if the unemployment rate is currently judged to be close to its normal longer-run level and the "normal" level of the real federal funds rate is currently close to its historical average."

How do you fix that if you're a labor economist who just knows, knows in her bones, that zero interest rates will ultimately lure back permanently displaced workers? Why you change the assumptions, of course! And that's just what she did.

In that same speech, Yellen went on to explain that if you substituted in her new and improved assumptions, the rule miraculously produced different results. She began with the supposition that despite how low the unemployment rate was, 'significant slack still remained in the labor market." She furthermore posited that it would be more reasonable to assume the historic equilibrium rate of two percent be replaced by zero based on the suggestion of "some statistical models."

Shortly after the speech, Taylor criticized Yellen's modifications, writing that "little or no rationale" was given to explain cutting the equilibrium rate to zero.

Taylor warned:

"This is a huge controversial issue deserving a lot of explanation and research."

Taylor summed up Yellen's approach of massaging the model as such:

"This gives the appearance that one is changing the rule or the inputs to the rule to get an answer. I do not think that reason would go over well in Congressional testimony."

And yet, so many of Taylor's peers in the economic community continue to feed policymakers' penchant for contorting the world into a fantastical one that only exists in those leaders' dreams. Is it any wonder so many of today's leaders in central banking sport God complexes?

Sadly, as has been the case so many times since the financial crisis broke, an opportunity has been squandered. A more aggressive path to normalization would have been appropriate as per Taylor's rule and even Yellen's own rule for gauging the fortitude of the labor market...then. Today it appears as if the current cycle has set sail for the history books. With interest rates grounded close to zero, the real question is what miracle can the Fed contrive for the attack on what's to come?

Given anxieties are ratcheting up fast, it will be hard to comply with this next request. But try. Try to set aside those worries for a moment and look as far out into the future as you can see. Picture the following: the economy has weathered the next recession and hopefully lived to fight another day. Now ask yourself this: What lessons might we apply from today to the post-recession world of tomorrow?

As yours truly marks the one-year anniversary of her departure from the Fed this week, a new kind of rule comes to mind. Call it the Common Sense Rule. Its input is experiential in nature drawn from economies across the globe. Its deployment is simple to the extreme:

Raise the floor on interest rates to two percent and vow to never again breach that raised floor.

Will such a radical commitment ever come to pass? It's impossible to say. But it would be a refreshing change from the norm that's prevailed for near on 30 years. And wouldn't it be a relief to return to a rules-based discipline instead of the smoke and mirrors of today's undisciplined approach where contrived language, convoluted math and the always popular throwing spaghetti against the wall to see what sticks are employed with disastrous results?

Acknowledge that there is no single certainty in this world other than that of uncertainty. Or as Taylor himself wisely observed:

"Uncertainty exists in the real world; you can't ignore it whether you use rules or discretion."

Waiting for the Godot of central banking has caused this nation undue harm by anesthetizing U.S. politicians and households to the inherent dangers of over-indebtedness. Period. End.

That said, with all deference to Ron Paul and his acolytes, the Fed does not need to be ended. We are not, nor ever shall be, a third world banana republic. Therefore, a central bank in some form is a given.

That is not to deny that the Fed is sorely in need of reform. In fact, a total re-engineering would seem to be in order, applying the same methods many of us learned in business school. Who said that in order to exact meaningful change, one must first create chaos? Let's do just that.

Vanity has no place in central banking, nor should it. But that very weak and vainglorious predilection seems to have nevertheless crept into a group of leaders tasked with staying above the fray. We can hope that public outrage tempers the hubris driving our current monetary policymakers to such extremes. We can hold out for Common Sense ruling the day. Let there not be those among us "So Vain" that they believe it is all about them and not "We The People."

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