John B. Taylor Stanford University January 8, 2000 Comments on Athanasios Orphanides’ The Quest For Prosperity Without Inflation John B. Taylor Stanford University January 8, 2000

Overview “Instant replay” of monetary policy decisions from the start of the Great Inflation through 1993. Postulates what information was available and was used to make the decisions Definition of “real time” data Calls attention to the problems with historical studies that simply use current data to evaluate past policy decisions. Clarida, Gali, Gertler, Judd, Rudebusch, Taylor Dramatizes the uncertainty about potential GDP Also about deviations of actual GDP from potential. Criticizes monetary policy rules with the level rather than the change in such deviations.

Constructive criticism Pointing out the implications of uncertainty in measuring potential GDP is useful and welcome. an issue about which we are all aware it is why there is so much research on estimating potential Historical charts are wonderful. However, the measure of uncertainty is flawed conceptually, exaggerated in magnitude overemphasized in comparison with other problems One is left with serious doubts about the message.

The key assumption Historical decisions with a monetary policy rule require old, un-revised data on inflation, real GDP and potential GDP no problem for real GDP or inflation But there is a problem about potential: no record of a potential series produced at the Fed in 1960s and 1970s Answer to the problem? Assume that the Fed used the series produced by the White House Analogous to assuming a can opener

Reasons to question the assumption and thus the conclusion Potential GDP and its growth rate became politicized as early as the late 1960s Serious economic analysts—like Burns and Greenspan—paid no attention to it The series shows a GDP gap of 15 percent in the mid 1970s—comparable to the Great Depression! Economists knew that the revision in 1977 was still too small. Even though paper claims that “this could not have been know in 1997.” Done by a lame-duck CEA that still pulled back from staff estimates (e.g.. 4.9 percent u*) Concept of potential GDP was a max not a mean

Reasons to worry about reacting to y only rather than to y Overshooting: Policy is too easy when economy is way above capacity and growing at potential growth rate Undershooting: Policy is too tight when economy is below capacity and growing at potential growth rate Econometric model-based evidence: Rudebusch (1999): modern forward/backward looking model (with estimates of uncertainty in potential) Taylor (1985) VAR type model Also worry about loaded words: “prudent” versus “active,” with cites to Friedman Meltzer

Maybe not so prudent recently (using real time data (Fig 20))

Residuals as Mistakes Deviations from policy rules cannot be blindly interpreted as mistakes: some discretion is needed. Clearly the inflationary policy in the late 1960s and 1970s was a mistake. But the response to the 1987 stock market crash was not a mistake. What about the high interest rates at the end of the great disinflation that were a deviation from a policy rule? Strongly disagree with the following unqualified statement: “This ‘mistake,’ Taylor concludes, accounts for the dismal performance of output in the early 1980s and the depth of the 1982 recession.”

Conclusion Uncertainty in measuring potential is a problem Down weight output deviations: Rudebusch, Smets 0.5 is already pretty low, but perhaps it could be lower 0.0 seems too low 1.0 seems too high Spend a lot of time researching productivity growth and unemployment measures Look at other variables, such as capacity utilization or unemployment, that help estimate the GDP deviations