In my previous post I noted that (a) for the period from June 2003, when the FOMC lowered the funds rate to 1 percent, through June 2004, when they began the current string of rate increases, the federal funds rate was somewhat lower than would be predicted by a Taylor rule describing "typical" Fed behavior on the basis of realized inflation and deviations of output from it's "potential"; and (b) that departure has disappeared as a result of FOMC rate decisions since that time. Here's a version of the graph I showed in that earlier post, isolating the period since 2000.
In commenting on the Thoma/Ritholz Econblog debate, Max Sawicky has this to say:
Mark Thoma defends the Fed's "inflation-targeting" in today's WSJ econoblog debate. Mark is liberal, well-intentioned, and knows a lot more about monetary policy than me, but I can't get the past the fact that the labor market is anemic and the most likely relief can only come from the Fed.
Max's position seems to be that the FOMC's focus on price stability has driven it to ignore the real side of the economy. In his part of the Econblog discussion, Mark does point out that price stability and output stability are not, within the boundaries of what monetary policy can achieve, necessarily at odds. But even beyond that, the vision of a Fed that is impervious to real weakness in the economy just doesn't seem justified by the facts. Here's a picture of what the Taylor rule prescription would be if we assumed the Committee decided to ignore the output gap completely:
So, it seems that even given falling rates of inflation over the period the FOMC was expressing concern about disinflationary pressures, the funds rate chosen was lower yet as a result of GDP falling short of its long-run potential.
Does that mean, as some have suggested, the central bank has downgraded it's concerns about the evolution of inflation? Don't think so. Here's a picture similar to the one above, assuming that the FOMC has been reacting to output gaps, but not inflation:
Put the two pictures together, and what do you get? A monetary authority with a dual mandate, that faithfully -- and consistently -- pursues both.
A few technical notes for the geeks:
-- The estimated Taylor rule in these two posts is "inertial" -- it includes one lag of the funds rate, thus incorporating an interest-rate smoothing motive. The empirical specification also includes a first-order moving-average error term (although that really doesn't play a very large role). The output gap is measured relative to Congressional Budget Office estimates of potential.
-- No, I did not use real-time data. Yes, I know that is an important issue.
-- Although I do say that these Taylor rule experiments suggest the FOMC behaves "consistently," note that I did not say optimally. As we all know, that is much trickier issue.