Fed Chair Janet Yellen to Follow Reagan's 'Taylor Rule'

U.S. Federal Reserve Chair Janet Yellen gave her first speech on monetary policy since she took office from retiring Chairman Ben Bernanke. 

Yellen made it clear she is focused on moving Federal Reserve (Fed) policy back to the “Taylor Rule” that was first implemented during President Reagan Administration and for the next 30 years resulted in a period of low inflation and high economic growth. Conservatives and the youth should be optimistic that America is moving back into that “shining city on a hill.”  

Yellen said that after five years of modest economic growth from the lows of the financial crisis and the Great Recession, employment has only recovered to the pre-crisis level despite the 24 million in population growth. She specifically complimented the growth of production industries for leading the recovery and stated that the economy would be fully recovered within two years. Her bullet points on the economy were:

• Long-term unemployed and those workers who gave up looking for work are starting to get jobs from the recovery. 
• Service sector job are not the place to be in the future because Americans’ conspicuous consumption spending habits have diminished.
• Low inflation readings are temporary and will soon rise from 1.5% to 2%.
• Full employment rate is 5.4% and the economy will be there by 2016. 

Yellen emphasized there were three big questions for the Fed in setting interest rates:

Q 1:  Is there still significant slack in the labor market?

A: This is a tricky question for the Fed to answer. If the population is getting older and retiring, there will be room for Millennials to get good jobs at good wages. If not, Millennials better get used to working three part time jobs, making peanuts, and continuing to live in their parents’ basement.

Q 2:  Is inflation moving back toward 2 percent?

A: The Yellen Federal Reserve is more concerned about inflation taking off than the Bernanke Fed. If inflation moves up, the Yellen Fed will raise short term interest rates and slow the economy. Although Yellen does not think that she will lose control of inflation, she will play hardball on the economy to stop a big inflation spike. If this happens, Millennials should expect to move back in with their parents.

Q 3:  What factors may push the recovery off track?

A: Yellen refreshingly admits that there are a lot of issues that the Fed cannot and should not try to fix. A sovereign debt and banking crisis in Europe is still a big risk to causing real damage to economies around the world, including the U.S. She also believes the Fed was fortunate that their quantitative easing money printing scheme did not create another disastrous asset bubble and make things worse for Americans. 

Yellen sees herself as the new sheriff in town, who will only bail out the economy if she is forced to respond to a very big disaster like a foreign banking crisis or some national crisis like 9/11. On her watch, the Fed is going to be very transparent about its intentions so that the public can better prepare for the future. 

Chair Yellen stated she wants to return to the days of the Fed being available as an “automatic stabilizer.” To economists, this is code for bringing back the “Taylor Rule,” which was established during the Presidency of Ronald Reagan and allowed for a 34-year period of low inflation and superior economic growth called the “Great Moderation.” 

The rule establishes a simple and transparent formula that the Yellen Fed can follow in setting the level of interest rates based on changes in inflation and economic output. Most importantly, the rule stipulates for each 1% increase or decrease in inflation, the Fed will raise or lower the interest rate by more or less than 1% in the same direction. The Taylor Rule has an imbedded political guillotine. If Congress goes on a deficit-spending binge that causes inflation, the Fed automatically jacks up interest rates faster than inflation. The result will be a recession and the public will retaliate against Congress in the next election. 

This Rule’s 30-year efficiency in disciplining Congress probably explains why John Taylor, who was serving as the Treasury Undersecretary in President George W. Bush’s Administration, did not get the President’s appointment as Chairman of the Federal Reserve on February 1, 2006, when Ben Bernanke was appointed.

Today was a great day for Americans who want to reign in government spending, maintain low inflation, and enjoy strong economic growth. Chair Yellen is reviving policies that are known to have been good for all Americans.

The author welcomes feedback and will respond to comments by readers.