Why Are so Many People so Eager to Think Monetary Policy Is Unsustainable Market Manipulation?: A Puzzle

A John Taylor & company smackdown from 2013: a topic that I want to get back to—not so much his argument (which is foolish), but the fact that it was then so popular to claim that the Bernanke Fed...

A John Taylor & company smackdown from 2013: a topic that I want to get back to—not so much his argument (which is foolish), but the fact that it was then so popular to claim that the Bernanke Fed's QE policies were unfair & unsustainable…

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In a full-employment or near full-employment economy, the level of interest rates cannot stay “too low”—below r*—indefinitely. The level of the yield curve is pinned down from below by the requirement that the central bank hit its inflation target. If the central bank tries to push and keep the yield curve configuration too low, sooner or later there will be too much demand chasing the supply, and inflation—which the central bank will not allow.

But in an unemployment sticky-wages sticky-prices fixed-debt economy, there is no countervailing reason why the level of interest rates cannot simply sit above r*, with lots of unemployment and idle capacity. Nothing keeps the central bank from doing that.

Now comes (or rather came: John Taylor wrote this piece of foolishness back on January 28, 2013) John Taylor to say that central-bank actions in a depressed economy to push the yield-curve configuration down—from above r* to something closer to r*—were like rent control in the housing market: an illegitimate, damaging, and unsustainable governmental price control:

John Taylor: Fed Policy Is a Drag on the Economy: ‘The “forward guidance” policy…. Investors are told by the Fed that the short-term rate is going to be close to zero…. [This] keeps the long-term rate low…. Effectively the Fed is imposing an interest-rate ceiling on the longer-term market…. When this ceiling is below what would be the equilibrium between borrowers and lenders… this is much like the effect of a price ceiling in a rental market where landlords reduce the supply of rental housing. Here lenders supply less credit at the lower rate. The decline in credit availability reduces aggregate demand, which tends to increase unemployment, a classic unintended consequence of the policy… <https://www.wsj.com/articles/SB10001424127887323375204578267943236658414>

This was and is simply and totally completely and unconditionally 1000% foolish.

With rent control—or any other price ceiling below a market-equilibrium price—there are more buyers who want to buy at the ceiling price than there are sellers who want to sell. The economic losses come from the deals not done as willing buyers at that price cannot find sellers. But where are the borrowers (buyers) who cannot find lenders (sellers) in the bond market? Nowheresville. The “ceiling” is not a government-imposed constraint blocking transactions that would otherwise occur. The “ceiling” is, instead, a metaphor for how the central bank has chosen what the market equilibrium price will be.

I do not know whether John Taylor did not understand how a rent-control ceiling that enforces a non-equilibrium market price is different from a central bank’s decision to run monetary policy in such a way that the equilibrium market price is low, or whether he does understand but simply wanted to go with an inapplicable metaphor.

From my perspective, the most interesting thing was how much traction John Taylor’s argument had with people who really ought to have known better. I tried to think through why it did so. I am not satisfied with what I wrote back then, a decade ago, and now the decade-tickler to rethink this has popped up again in my to-do list.

So I will start by putting my—inadequate—past thoughts on why Taylor and others got so confused behind the paywall: