The inventor of the 'Taylor Rule', said to be generally followed by leading central banks the world over, is worried that that Federal Reserve may have gone out too far ahead on a limb with its monetary policy in order to stimulate the United States economy.
In an interview with CNBC-TV18's Menaka Doshi, Standford professor John Taylor spoke about the prospects of the global economy going into the next year, including risks it faces from quantitative easing policies followed by the US, Europe and Japan.
The 'Taylor rule' stipulates by how much central banks should raise interest rates in response to a rise in inflation or economic output.
Also read: Fed confident on US growth, opens door wider to rate hike
Below is the transcript of the interview on CNBC-TV18.
Q: Let me start first with the good news. The latest US GDP number of 5 percent indicates a fairly robust recovery. Do you think the Fed will hike rates exactly after the promised two meetings of no action?
A: Yes I think it is. It is about time that we move back to a more normal monetary policy because the interest rate has been zero since the crisis. We have had a lot of unconventional policies as well. So, yes it is about time.
In many respects the recovery so far has been disappointing. It is slowest recovery we have had from a similar kind of crises. However now that it is pretty clear that we are effectively at a normal time again, it is appropriate for the Fed to begin to make the moves and I think they will.
Q: In that case do you worry that the Fed will be concerned that inflation is not at its target of 2 percent. In fact falling commodity prices may push the inflation index even lower. Will that stay the Fed's hand?
A: The inflation rate is just a bit below the 2 percent target. Again based on what has worked for monetary policy in the past with an inflation rate over 1 percent, with the economy getting close to normal all historical precedent would be that you would have a positive interest rate even by now quite frankly. So, that is what the Fed is aware of. They don't want to get behind the curve.
With respect to the oil prices, it is a dramatic fall and that will affect the inflation rate but these are more temporary effects. Monetary policy makers around the world recognise that. So, ultimately the concern is with the longer term rate of inflation. If they begin to react too much to the short term effects it begins to have negative impact on the economy.
Q: You have long argued against quantitative easing but now Europe looks set to go down that path early next year. Some buying of even government bonds looks imminent over there. Do you think they should go down that path at all?
A: To give some perspective to this, the quantitative easing in the US has not worked. If you go back and look at this recovery – [it was] very slow. The first attempt to unwind it last year caused lot of turbulence in the US and the global economy. The more recent one has been better because it has been more strategic. Overall this has really not helped as far as people who have looked at it carefully can tell.
However what it has done is affected currency markets. You first saw the reaction to that in Japan with their quantitative easing and to some extent you see in the reaction in Europe with theirs. These attempts to move to quantitative easing has made the dollar stronger. I think that has been their motive. Ultimately if you went back in history and thought of all the quantitative easing around the world we would have been better off without it. However we are there now and Europe is in a situation where they have to deal with the situation as it stands.
Q: Do you see and European economic recovery by the end of 2015?
A: All of this depends on the policy. One of the things I have been emphasizing since before the crisis is that when we get off track on policy, things don't work so well. You can see that looking at different countries at different periods in time. US for example had an amazing strong economy in the 80s and 90s, we got off track and we had this crisis and slow recovery. Hopefully we will be back on track.
Europe's problems go back a little further as their unemployment rate has been so high, it is distressing. So, to say that they are going to recover in less than a year is very optimistic. However I think the idea of change in the policy is now again focusing on these issues which will give stronger growth, longer time it will help employment and that is what they should be doing.
Q: Japan too is all set to embark on another wave of quantitative easing (QE) with the return of Shinzo Abe after the elections. Even here do you see quantitative easing resulting in a recovery in Japan?
A: Once again the quantitative easing in Japan began more recently with Abe as he appointed Kuroda to run the Bank of Japan. I think that is best seen as a response to quantitative easing elsewhere in the world because the yen got very high. With this new action the yen has depreciated and that is thought to be important for the recovery in Japan.
However the other part of this new policy, they call it the third arrow and that brings me back to my main concern here is there has not been much progress on the longer term things that the Japanese economy needs to do. So, you do see effects of QE, I think larger in exchange markets. You are not seeing much effect elsewhere yet. There is lots of turbulence with the tax increase. The main impact now they are going to postpone this tax increase and that is probably good thing to do in Japan, that will be a positive.
Q: With dollar being the world's currency US bonds are bought by all countries with dollar reserves – China, Russia, Japan, India, in a sense US can have a looser monetary and fiscal policy than other countries. Is that the defining advantage in the US and help QE succeed?
A: It is an advantage. There is more demand but that can flip back again. You have to recognize there may be a time where people say we are not going to buy so many treasuries and we need to be aware of that.
What can actually appear to be advantage can be a disadvantage if we become complacent and we say don't worry we can just sell our bonds to the rest of the world and then suddenly they change. In addition that has to be paid back, interest has to be paid back. So, in general it is a false view that it is an advantage.
Ultimately you have got to think about this globally as well to the extent that countries borrow or lend too much in other currencies and as exchange rates move it can be risky. We are seeing a little bit of that now with respect to the movements of the dollar. Some countries have said we are now going to have to pay back these dollars and that is going to cause them some problems. It could come back and feedback on the whole world economy.
Q: A key trend this year has been the huge rise in the US dollar especially vis-à-vis the euro and the yen. Even [Fed vice chair] Stanley Fischer sometime back worried about the dollar strength and said it might postpone the Fed's rate hike decision. Do you think further dollar strength can stymie US recovery?
A: I don t think so. There are countervailing forces here. US economy does have some momentum. I would not focus on the dollar strength at this point as a negative. To me the more serious negatives are just basic kind of policies. Is monetary policy going to be too delayed, is regulatory policy going to continue to intervene more than it should. Those are the concerns that I have.
I think at this point the strength of the dollar, the relative weakness of the euro and the yen during the period you mentioned is undoing or is reversing something that occurred in the other direction where the yen was very strong and the euro was very strong. So you need to put this in a longer term perspective. I don't think it is going to be a negative to the US economy in the near term.
Q: Do you see dollar rising even more in 2015 given the weakness in the euro and yen and their economies? Will strong dollar be one key feature of 2015?
A: I think you have already seen it. Markets don't just look at the past they look at the future and they have been seeing the Fed ending its quantitative easing at least the purchases of additional securities, increasing the balance sheet, they have seen that diminishing and simultaneously they have seen Japan and Europe go in the other direction or in the case of Europe at least talking about it. So, that affects their expectations and affects the currency. So, the movements that you have already seen in the currency reflect those changes in policies.
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