Wednesday Wisdom

WHO?

Sorry for the click bait, but no its not that Taylor, even though she has the GDP of a small nation. I am referring to John B. Taylor, an American economist who has held various positions in academia, government, and public policy.

Taylor received his Bachelor of Arts degree from Princeton University in 1968 and his Ph.D. in Economics from Stanford University in 1973. He is the Mary and Robert Raymond Professor of Economics at Stanford University and the George P. Shultz Senior Fellow in Economics at the Hoover Institution.

What he produced

Post WW2, an economic school called The Keynesians dominated the macro-economic landscape and influenced US monetary policy. They believed that aggregate demand was the key indicator for the economy and believed the government intervention and spending could control the economy. In 1971 the United States went off the Gold Standard where the dollar was pegged to an amount of gold. The goal was to give the economy more flexibility, the ability to grow faster and give Federal policy makers more control over the money supply. This led to the rise of the Monetarists school of economics championed by Milton Friedman, who believed in controlling the money supply to support growth and fight inflation. All these policies were discretionary and didn’t provide the proper amount of economic or inflationary stability.

Taylor is well-known for developing the "Taylor Rule," a guideline for central banks to set interest rates based on inflation and economic output. Rather than a discretionary economic policy, Taylor provided a rules-based and formula policy process making the Federal Reserve more transparent and less whimsical. This rule as a monetary policy guideline and formula was first proposed by Taylor in 1993. It suggests a target for the central bank's short-term interest rate based on economic conditions of growth and inflation. The rule is intended to guide central banks in setting interest rates to achieve both price stability and maximum sustainable employment. The Taylor Rule is forward-looking, meaning that it advises policymakers to anticipate future economic conditions and adjust interest rates accordingly. It reflects the philosophy that central banks should act preemptively to prevent excessive inflation or economic downturns. One of the underlying principles of the Taylor Rule is the desire to stabilize the economy by avoiding extreme fluctuations in inflation and output. By providing a systematic approach to adjusting interest rates, the rule aims to contribute to economic stability.

The original form of the Taylor Rule is expressed as follows:

r = p + 0.5y + 0.5(p - 2) + 2

Where:

• r = nominal fed funds rate

• p = the rate of inflation

• y = the percent deviation between the current real GDP and the long-term linear trend in GDP 

The Taylor Rule emphasizes the importance of maintaining price stability by targeting a specific inflation rate. Central banks are encouraged to adjust interest rates to achieve and maintain the target inflation rate. The Taylor Rule implies that when the economy is overheating (output above potential and inflation rising), the central bank should raise short-term interest rates. Conversely, when the economy is below potential and inflation is low, the central bank should lower short-term interest rates to stimulate economic activity. This is done through the Federal Funds rate and the Federal Reserve achieves this by selling bonds which reduces money into the system and raises rates or the other way in a process known as repurchase agreements better known as repos (or reverse repos). *

The rule takes into account the concept of the output gap, which is the difference between the actual and potential levels of output in the economy. It suggests that central banks should consider the state of the economy in relation to its full capacity when setting interest rates. The formula for the nominal interest rate in the Taylor Rule is often expressed as the sum of the inflation rate and the output gap, adjusted by mathematical coefficients. The rule provides guidance on how much interest rates should be adjusted in response to deviations of inflation and output from their target or potential levels.

2024 why do we care?

Taylor Rule represents a systematic approach to monetary policy based on economic principles, empirical analysis, and a philosophy that emphasizes the importance of stabilizing inflation and output. Its logic is grounded in the belief that adjusting interest rates in response to economic conditions can contribute to achieving macroeconomic stability. The Taylor Rule embodies a philosophy that recognizes trade-offs between inflation and output stabilization. It acknowledges that policymakers must balance these objectives when setting interest rates.

The Taylor Rule itself is primarily an empirical and practical tool rather than a comprehensive philosophy, however its foundations are rooted in economic principles, logic, and the philosophy of monetary policy from the Keynesians to the Monetarists.

Managing a 27 trillion-dollar economy like the United States is a complex task that is wrought with many variables and changing conditions and policymakers need to adapt or modify the rule to suit the specific circumstances of the economy. By having a logical rules-based process rather than a discretionary one, the Federal Reserve has a “First Principle” approach where they break the complexities down to simple and fundamental truths to solve the complex ones.

As market participants await more economic data on inflation and the economy, it leaves us to ponder if Taylor’s logical approach to monetary policy will continue to be successful and worthy of a Nobel prize in economics.

• *When bond prices go up from more demand, the interest rate of that bond goes down as an inverse relationship.

And now you know...

Thanks, Dad, for the gift of curiosity!

Philosophy is the art of thinking, the building block of progress that shapes critical thinking across economics, ethics, religion, and science.

METAPHYSICS: Literally, the term metaphysics means ‘beyond the physical.’ Typically, this is the branch that most people think of when they picture philosophy. In metaphysics, the goal is to answer the what and how questions in life. Who are we, and what are time and space?

LOGIC: The study of reasoning. Much like metaphysics, understanding logic helps to understand and appreciate how we perceive the rest of our world. More than that, it provides a foundation for which to build and interpret arguments and analyses.

ETHICS: The study of morality, right and wrong, good and evil. Ethics tackles difficult conversations by adding weight to actions and decisions. Politics takes ethics to a larger scale, applying it to a group (or groups) of people. Political philosophers study political governments, laws, justice, authority, rights, liberty, ethics, and much more.

AESTHETICS: What is beautiful? Philosophers try to understand, qualify, and quantify what makes art what it is. Aesthetics also takes a deeper look at the artwork itself, trying to understand the meaning behind it, both art as a whole and art on an individual level. A question an aesthetics philosopher would seek to address is whether or not beauty truly is in the eye of the beholder.

EPISTEMOLOGY: This is the study and understanding of knowledge. The main question is how do we know? We can question the limitations of logic, how comprehension works, and the ability (or perception) to be certain.