Monetary policy since 2000

I just returned from the annual conference of the

Society for Financial Econometrics
hosted by the University of Chicago. One of the many interesting papers described changes in Federal Reserve policy over time.

One formulation commonly used to summarize Fed policy is the

Taylor Rule ,
which calls for the Fed to choose a higher interest rate when inflation is high and a lower interest rate when there is a big gap between the level of GDP and estimate of what the economy could produce at full potential. The Taylor Principle suggests that in response to a 1 percentage point increase in inflation, the Fed needs to increase the short-term interest rate by more than 1 percentage point in order to keep the economy on a stable path. A paper by Li, Li, and Yu presented at the SoFiE conference proposed that perhaps the Fed has been using different coefficients for this rule at different points in time. They estimated a regime-switching model that allows for such shifts. They identified some periods in which the Taylor Principle was adhered to (with a 1% increase in inflation leading the Fed to increase the interest rate by 1.5%), and others in which it was not (with a 1% increase in inflation leading the Fed to increase the interest rate by only 0.86%). The graph below plots their inferred probability that the Fed was in the accommodative regime at different historical dates. Their conclusion is that the Fed was not adhering to the Taylor Principle in the 1960s and 1970s, and returned to that accommodative regime again over the last decade.

Inferred probability that the Fed was in the accommodative regime. Source: Li, Li, and Yu (2010).

It's interesting to look in detail at their description of the most recent decade. The red line in the graph below denotes the actual 3-month T-bill rate over 2000-2007. The blue line indicates the interest rate the Fed would have set if it were following the historical pro-active rule, and fuchsia indicates the predicted rate under the accommodative rule. The Fed seemed to start out the decade following the pro-active rule and then switched to an interest rate even below the accommodative rule.

Red: actual 3-month interest rate; blue: level implied by stable Taylor Rule; fuchsia: level implied by accommodative Taylor Rule; turquoise: level predicted by regime-switching model. Source: Li, Li, and Yu (2010).

This provides an interesting confirmation of the theme of a talk by Stanford Professor John Taylor also given at the conference. Taylor argued that a shift away from the policies followed in the 1990s was one factor contributing to the excessive housing boom and subsequent problems. My personal view is that Taylor overstates the contribution of low interest rates, and that poor regulation of the shadow banking system was a more important cause of the problem.

Nevertheless, I agree that the lax monetary policy of 2003-2005 was a mistake.

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Jan Lokpal Bill is based on poor policy analysis

Pratap Bhanu Mehta reminds that that while Elephantiasis is a nasty problem, elephant dung is not the cure. Just because we're convinced that corruption is a serious problem, it doesn't mean that any vaguely proximate remedy is going to work. Mere moral outrage does not solve problems. Complex problems require cold thinking and sophisticated analysis.

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Did the Indian capital controls work as a tool of macroeconomic policy?

Ila Patnaik and I wrote a paper titled Did the Indian capital controls work as a tool of macroeconomic policy?

The abstract of this paper reads: In 2010 and 2011, there has been a fresh wave of interest in capital controls. India is one of the few large countries with a complex system of capital controls, and hence offers an opportunity to assess the extent to which these help achieve goals of macroeconomic and financial policy. We find that the capital controls were associated with poor governance, were unable to sustain the erstwhile exchange rate regime, and did not support financial stability. India's experience is thus inconsistent with the revisionist view of capital controls. Macroeconomic policy in India has moved away from the erstwhile strategies, towards greater exchange rate flexibility combined with capital account liberalisation.

This is interesting in the discussion on Indian economic policy. But this has also become surprisingly interesting on an international scale.



Many years ago, policy makers and academics had figured out capital controls. The old orthodoxy ran as follows. Capital account liberalisation was an integral part of the package of policies that made up a modern nation. Plugging into globalisation meant shedding autarkic policies, and being open to ideas, trade, services, capital, etc. All good countries had an open capital account. One by one, emerging markets started figuring out how to remove capital controls. This led to many blow ups along the way: A certain coherent apparatus is required, of fiscal, financial and monetary policy in order to play this correctly. So the path has been a turbulent one, where emerging markets have had to figure out this package, but the destination has been clear.



Policy makers and academics did not come to this conclusion from deductive reasoning. They came to this conclusion by getting bloodied over and over. The capital controls that were attempted did not deliver the desired results, and the capital controls that could deliver the desired results imposed too high a cost on GDP growth. The working consensus of practical people shifted away from capital controls.



In recent years, these questions have been reopened, most notably by the IMF. These questions are, hence, back in the global economic discussion.



But in the world today, most countries have opened up.  Among the G-20 countries, only India and China have a large and complex system of capital controls. In most places, practical experience with capital controls is actually hard to find. Many of the lessons of international experience from the 1970s and 1980s have been forgotten. It is, hence, particularly interesting to study the contemporary experience of India and China with capital controls. This makes our paper a useful component of this global debate.



And, on these issues, also see The IMF needs to find its voice again, by Sebastian Mallaby in the Financial Times. The Frank Warnock paper that he talks about is also worth reading.

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A new low for Indian economic policy

Strange things in the appointments process:

• 16 May: Deepshikha Sikarwar has a story in the Economic Times today titled I-T dept seeks former SEBI chairman CB Bhave's tax returns details.
  
  
• 25 April: Shaji Vikraman had a front page story in the Economic Times about how Bhave's team at SEBI was being dispersed. And, Mobis Philipose on these issues in Mint, and Sahad PV on VCCircle.
  
  
• 23 April: P. Vaidyanathan Iyer had a front page story in the Indian Express on how C. B. Bhave was removed.
  
  
• 18 April: Paranjoy Guha Thakurta on the problems of recruiting a successor for U. K. Sinha at UTI.
  
  
• 9 April: Subhomoy Bhattacharjee and Sunil Jain in the Indian Express on problems in the recruitment of a successor to U. K. Sinha at UTI.
  
  
• 5 April: An interview with C. B. Bhave in the Business Standard by Shyamal Majumdar and Rajesh Bhayani.

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