Emi Nakamura – Beyond the Taylor Rule

The Federal Reserve partially “looked through” the post-Covid rise in inflation and ultimately managed to bring about an “immaculate disinflation.” The Fed’s policy deviated strongly from the Taylor rule during this period. More generally, central banks with strong inflation-fighting credentials looked through post-Covid inflationary shocks yet experienced less inflation than more hawkish but less credible central banks. In light of this episode, we assess the degree to which the Taylor rule is descriptive, and the degree to which it should be viewed as prescriptive. While the Taylor rule (generally) fits well during the Greenspan period, it (generally) fits poorly in the early 1980s and after the early 2000s. Academic work has emphasized the role of the Taylor rule in preventing self-fulfilling fluctuations (guaranteeing determinacy). These concerns can be addressed with a shock-contingent commitment and are fragile to deviations from fully rational expectations. We discuss three reasons why optimal policy may not always imply a one-for-one response of interest rates to inflation (forward guidance, correlated shocks, and “long and variable lags”). The main challenge arising from such policies is not indeterminacy but erosion of inflation-fighting credibility and potential deanchoring of long-run inflation expectations. Only central banks with strongly anchored inflation expectations and large amounts of inflation-fighting credibility are likely to be able to look through inflationary shocks.