Emi Nakamura on Central Bank Credibility and the Taylor Rule

Summary

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Odd Lots Podcast Summary

Episode: Emi Nakamura on Central Bank Credibility and the Taylor Rule
Date: August 29, 2025
Hosts: Joe Weisenthal & Tracy Alloway
Guest: Emi Nakamura (Professor at Berkeley)

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Episode Overview

The hosts broadcast from the annual Jackson Hole economic symposium, focusing on a timely discussion with economist Emi Nakamura about her paper, "Beyond the Taylor Rule." The episode weaves together themes of central bank credibility, the limitations and evolution of the Taylor Rule, the post-COVID monetary response, and the global variation in central bank behavior. Nakamura offers nuanced insights into the complicated relationship between simple policy rules and effective, credible monetary policy in the face of modern shocks.

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Key Discussion Points & Insights

1. What Is the Taylor Rule and Why Does It Matter?

• Origins: John Taylor’s 1993 paper posited that the US Fed’s interest rate decisions could be described by a simple rule relating rates to inflation and the output gap (how “overheated” the economy is).
  • “People typically think of what the Federal Reserve and other central banks do as incredibly complicated...you could actually describe it by something very simple.” (Emi Nakamura, [02:54])
• Transition from Description to Prescription:
  • Initially descriptive, the Taylor Rule became a guide for “good” policy, influencing both academic theory and central bank decisions.
  • Deviations from the rule in periods like post-COVID have required central banks to justify their actions.

2. The Rule’s Limits and Context

• Recent Poor Fit:
  • “The Taylor Rule doesn’t fit all that well over the past 20 years... should we still view this as the benchmark for describing monetary policy?” (Emi Nakamura, [04:06])
  • The rule worked well until 2008 (Greenspan era), but failed during zero-lower-bound periods and post-COVID, not anticipating either the timing or magnitude of interest rate changes.
• Historical Context Matters:
  • In the late 70s/early 80s, tying policy to a rule helped bolster credibility amidst high inflation and political pressure. Today, reputational context is different.
  • “You kind of need to tie yourself to a mast... We are not going to just go by a mathematical rule.” (Emi Nakamura, [07:18])

3. The Taylor Principle and Its Real-World Application

• The Prescriptive Gap:
  • Taylor Rule suggests rates must rise more than one-for-one with inflation (the "Taylor Principle": coefficient >1). During COVID, actual rate hikes lagged dramatically.
    • “The COVID inflation saw the largest gap in history...in the US, this gap was over 10 percentage points.” (Emi Nakamura, [08:40])
• Why the Gap Exists:
  • Supply shocks (e.g., pandemic-driven bottlenecks) versus demand shocks require different responses.
    • In standard models, aggressive rate hikes make sense for demand-driven inflation, less so when supply-side shocks are culpable.
    • “Central banks...shouldn’t always follow the Taylor principle if inflation comes from supply-side shocks.” (paraphrased from [08:40–11:13])

4. Did the Fed "Do a Good Job"?

• Retrospective Assessment:
  • “If you look at what happened over the past five years, I think this is going to look like a soft landing...That is remarkable.” (Emi Nakamura, [12:20])
  • Key successes: Inflation fell quickly, no recession, long-term expectations stayed stable.

5. Central Bank Credibility and International Comparisons

• Early Risers vs. Late Risers:
  • Some banks (early risers) raised rates aggressively post-COVID, while "late risers" (US, Eurozone, Japan) moved more cautiously.
  • Paradox: Early risers faced worse inflation outcomes.
    • “Early risers...responded very aggressively to Covid inflation, but they actually saw inflation rise by a lot more...” (Emi Nakamura, [13:37])
  • Credibility is Key:
    • Central banks with strong anti-inflation reputations could “spend” their credibility to move gradually, whereas others had to react decisively to avoid unanchored expectations.

6. The Benefits of Credibility

• Policy Options:
  • Credible banks can implement optimal policy, potentially avoiding unnecessary recessions caused by overly aggressive rate hikes.
  • Forward Guidance:
    • “You can tighten monetary policy by talking about it, by saying stuff.” (Joe Weisenthal, [21:06])
    • Fed’s communication in 2021 moved bond markets before policy rates changed.

7. Future Risks to Credibility

• Potential for Erosion:
  • After a big inflation episode, people pay more attention—future shocks may require more aggressive early action.
    • “If we start to see inflation again, it’s going to be a much more rapid transition to where people will start to ask whether this is going to last longer...” (Emi Nakamura, [22:46])

8. Nature of Shocks: Demand, Supply, and Policy Response

• Identification is Hard:
  • Policymakers struggle to identify shocks in real time, but sometimes (e.g., COVID) the distinction is clearer.
    • “It is incredibly hard for policymakers to identify shocks... but sometimes they can, like in Covid.” (Tracy Alloway, [36:23])

9. Political Preconditions for Credibility

• Central Bank Independence:
  • Durable credibility often reflects political support and past hard choices (e.g., appointment of Paul Volcker).
    • “Could only happen in the context of political protection for the central bank, central bank independence.” (Emi Nakamura, [26:27])

10. The Enduring Role—and Limits—of Rules

• Technocratic Rules Are Valuable, But Not Sufficient:
  • Rules anchor expectations and should be the default for demand-driven shocks.
  • Flexibility is sometimes required for supply shocks or unique situations, ideally supplemented by clear communication.
  • Output gap estimation (“how overheated is the economy?”) is always part judgment—so rules are never fully automatic.

11. Notable Quotes & Moments

 

• “The Taylor Rule has achieved this incredibly dominant status... but the Taylor Rule doesn’t fit all that well over the past 20 years.” — Emi Nakamura ([04:06])
• “The COVID inflation saw the largest gap in history. For the United States, this gap was over 10 percentage points.” — Emi Nakamura ([08:40])
• “Did the Fed do a good job?” — Joe Weisenthal ([12:11])
• “This is going to look like a soft landing.” — Emi Nakamura ([12:20])
• “Central banks with strong anti-inflation reputations could ‘spend’ credibility to move gradually.” — (summary of [13:37])
• “You can tighten monetary policy by talking about it, by saying stuff.” — Joe Weisenthal ([21:06])
• “Even with rules, you can never quite escape human judgment.” — Joe Weisenthal ([29:45])
• “Those expectations of low inflation were hard won...it’s certainly something that can dissipate.” — Emi Nakamura ([22:46])
• “Technocratic rules like the Taylor rule...should be the default...but at times you may want to use forward guidance in other ways.” — Emi Nakamura ([30:35])

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Timestamps for Important Segments

• [02:54] – Nakamura explains the Taylor Rule and its mythic status.
• [04:06] – On why the Taylor Rule has not fit recent decades.
• [08:40] – COVID inflation and the largest-ever gap between rule and action.
• [12:20] – Assessment of the Fed’s COVID response: “Soft landing.”
• [13:37] – Differentiating early and late riser central banks; credibility discussion.
• [18:31] – Benefits of credible central banks.
• [21:06] – Importance of forward guidance and central bank communication.
• [22:46] – Likelihood of more aggressive responses in future episodes.
• [26:27] – The role of politics in central bank credibility.
• [29:45] – Human judgment’s inescapable role in rule-based policy.
• [30:35] – Flexibility, forward guidance, and rule limitations.
• [33:19] – On demand vs. supply shocks and supply-chain constraints.
• [34:11] – The difficulty in real-time shock identification.

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Notable Takeaways

• The Taylor Rule is both a useful anchor and an oversimplification; credibility and judgment remain essential.
• Central banks with reputational capital have been able to “spend” it by being less reactive, avoiding unnecessary recessions after supply shocks.
• There is no escaping human judgment in policy setting—even with technocratic rules, estimation and context matter.
• Forward guidance (the power of words and expectations) is a potent monetary tool in modern times.
• Policymakers must recognize when to adhere strictly to rules and when unique shocks require discretion—especially in an era where credibility can be quickly lost, but is crucially hard to regain.

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This summary captures the heart of a nuanced and timely conversation on the evolution of monetary policy rules, the value of credibility, and the importance of context, all explained with clarity and insight by Emi Nakamura and the Odd Lots hosts.

Transcript

[Lisa Mateo]

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[Emmy Nakamura]

Bloomberg Audio Studios Podcasts Radio News.

[Tracy Alloway]

Hello and welcome to another episode of the Odd Lots Podcast. I'm Tracy Alloway.

[Joe Eisenthal]

And I'm Joe Eisenthal.

[Tracy Alloway]

Joe, we're back in Jackson Hole.

[Joe Eisenthal]

Jackson Hole. I love it here.

[Tracy Alloway]

It's beautiful. It's beautiful. And not only do we get a chance to enjoy the gorgeous scenery, we get a chance to talk economic policy.

[Joe Eisenthal]

There's so much going on right now, to say the least. We don't need to recapitulate. Everyone knows what's going on right now. There's so much stuff, whether we're talking about the macro situation, whether we're talking about whatever.

[Tracy Alloway]

I love how you say there's no need to recapitulate and then you immediately do it.

[Joe Eisenthal]

But there's just so much going on.

[Tracy Alloway]

I think you're hitting on like a couple things, which is there are these different themes floating through the conference. So obviously, obviously you have uncertainty over what tariffs actually do to the economy. Like what type of shock are they? Do they destroy demand and therefore maybe cause deflation, or do they lead to companies passing on those costs and cause inflation? There's central bank independence, which everyone wants to talk about. And there's obviously the direction of short term interest rates.

[Joe Eisenthal]

And then of course, the formal and then of course the formal theme of the conference about labor markets. Labor markets and all this stuff. So yes, many different things going on.

[Tracy Alloway]

All right. Well, I am very pleased to say that there is in fact one paper that ties basically all these themes together. So we have the author here and really the perfect guest to talk, someone.

[Joe Eisenthal]

We'Ve wanted to talk to for a long time.

[Tracy Alloway]

Absolutely. We're going to be speaking with Emmy Nakamura, a professor at Berkeley and the author of a paper being presented at Jackson Hole called Beyond the Taylor Rule. So Emmy, thank you so much for coming on odd lots.

[Emmy Nakamura]

It's great to be here.

[Tracy Alloway]

Let's just start. What is the Taylor Rule before we.

[Joe Eisenthal]

Can go beyond it?

[Tracy Alloway]

Ye. Yeah.

[Emmy Nakamura]

Well, in 1993, John Taylor wrote a paper in which he showed that the behavior of the Federal Reserve could be described by this remarkably simple rule as a function of inflation and what people call the output gap, which is sort of a measure of how overheated the economy is. And this was very surprising to people because people typically think of what the Federal Reserve and other central banks do as incredibly complicated. And so the surprise was that you could actually describe it by something very simple. And since that time when John Taylor wrote his original paper in 1993, the Taylor Rule has achieved more or less mythical status within economics and the policymaking world. The original paper was mostly descriptive. Like I said, it was pointing out that the behavior of the Fed, which seemed complicated, could actually be described as something really simple. But since then, it's really become a guide for prescriptive monetary policy. And when central banks deviate from the Taylor Rule, they're often asked to explain why this was a major theme in the post Covid inflation, for example.

[Tracy Alloway]

So on that note, could I ask why the Taylor Rule specifically and talk to us maybe about the process of how these papers come into being ahead.

[Emmy Nakamura]

Of Jackson Hole, why we wrote about the Taylor Rule. Well, as I said, the Taylor Rule has achieved this incredibly dominant status within not only the academic literature on monetary policy, but also within the policy community. And yet when I teach students, one of the things that's somewhat uncomfortable is that the Taylor Rule doesn't fit all that well over the past 20 years. So it fit pretty well during the Greenspan period and all the way until about 2008 in the United States, but it hasn't fit very well since then. First of all, there was the zero lower bound period when interest rates were just at zero. But it also didn't predict very well either the timing or the magnitude of the liftoff from zero interest rates. So given that 20 years is starting to be a long time, the question is, should we still view this as the benchmark for describing monetary policy? And then there's this second question about how to think about good monetary policy. So when John Taylor wrote his original paper, it was mostly descriptive paper, but he did point out that this was a time period. The time period he said was actually only six years. It was from 1987 to 1992. But he pointed out that this was a time period a lot of people thought of as representing good monetary policy. So while the paper was mostly descriptive, he did say, you know, well, maybe this is a guide to good monetary policy too. And that's a theme that a lot of people have picked up on since then. And we thought it was important to sort of reinvestigate that theme.

[Joe Eisenthal]

But this is funny, right? Because there is this tension of whether it's a descriptive or a prescriptive thing. And I've heard for years, people on tv, it's like, oh, the Taylor rule says it should be a lot higher, or the Taylor rule says it should be lower or whatever.

[Tracy Alloway]

But we just heard it from Jeff Schmidt at the Kansas Fed, Right.

[Joe Eisenthal]

And yet this is all based on basically a sort of backing out description of five years of monetary policy. That.

[Emmy Nakamura]

Six years.

[Joe Eisenthal]

Six years. Okay, sorry, six years. Maybe not quite. So can you talk a little bit more about, though, this? I don't know if it's a debate or how people think about prescriptive versus descriptive within this role.

[Emmy Nakamura]

So the tension that you're describing is exactly what motivated us to write this paper. Because it's interesting how a framework like this, which is so simple and so powerful in terms of describing monetary policy, and does say some things that are very true about what monetary policy should do in terms of leaning against inflation, leaning against an overheating economy, can end up becoming maybe more than even the author intended as a prescriptive rule. And one of the things that we want to remind people of is the historical context for when John Taylor's paper was written. So it was written in 1993. This was a period when the Fed was coming off some very difficult years for monetary policy. So the 1970s and 1980s were very difficult years for monetary policy. Inflation had been very high in the late 1970s and early 1980s. The Fed's reputation was, to say the least, limited. As an inflation fighter, inflation expectations were not nearly as anchored as they are today. So it was a very different time. And I think some of the context for John Taylor's paper is saying that when you have those kinds of reputational challenges, sometimes you kind of need to tie yourself to a mask and say, we are not going to just go.

[Joe Eisenthal]

By a mathematical rule.

[Emmy Nakamura]

Exactly. Because the 1970s are also one of the time periods in history which is best known for political pressure on the Fed. And so in the context of that kind of political pressure, one of the things you want to think about doing is giving people a very simple observable metric for how you adjust interest rates. But then of course, by several decades later, the Fed's reputation had changed pretty dramatically. We had seen decades of low and stable inflation and the Fed and other central banks around the world had really developed a very strong inflation fighting reputation. And so then the question arises, is the same kind of tying your hands approach appropriate even in the context of shocks like what we saw after Covid? And so this is the sense in which I think, you know, this is a time at which we want to ask these questions.

[Tracy Alloway]

It reminds me very much of the SOM rule and the arguments there that if you find like a specific number, the idea is that you use a sort of simple formula and then you immediately jump into action. So on that note, one of the key things about the Taylor rule is that it suggests rates need to rise by more than one for one with inflation. To properly offset inflation, you have to go in very, very strong. But you found in your paper that that's not always the case.

[Emmy Nakamura]

Exactly. So even beyond the idea that you want to raise interest rates more than one for one. So it's the coefficient is 1.5 in the Taylor rule. But there's the idea, even beyond that of the Taylor principle, which is exactly what you described, that you want to not only raise interest rates, nominal interest rates with inflation, but you want to raise real interest rates. And if you want to raise real interest rates, then you have to raise nominal interest rates more than one for one. Exactly what you said. And so that's kind of a core idea. And it's one of the main reasons why the gap between the Taylor rule prescription and what central banks actually did during the COVID inflation was so large. And actually for the United States, this gap was over 10 percentage points. So we are talking about a very large gap. And the COVID inflation saw the largest gap in history. So why does that not actually happen always in monetary theory? Well, the reason is because there are different sources of inflation. So the motivation for leaning hard against inflation that is probably pretty intuitive to most people is demand driven inflation. So when inflation is coming from an overheating economy, then there's this notion in monetary economics that you can satisfy all objectives of both, kind of calming down the economy, but also keeping inflation in check by raising interest rates pretty aggressively. And actually, optimal monetary policy theory implies you might even want to be more aggressive than the Taylor rule. But in contrast, when you have shocks to inflation that don't come directly from an overheating economy, but also come from other sources of increases in costs. So the supply shocks that people talked about during the COVID inflation period, then these same models can imply very different predictions. They can imply that you don't want to raise interest rates nearly so much in response to inflation associated with these kinds of shocks. So in our paper, what we do is we use a very standard monetary model and we simulate data from this model where we assume that the monetary policy is actually exactly optimal so the central bank is really doing the right thing. And then we run regressions where we try to estimate what you get for the Taylor rule in this context. And then the interesting observation is that you find that actually a lot of times the coefficient on inflation is less than 1. Sometimes it's close to 0, sometimes it's even negative. So really a lot of things can happen when you deviate Only from this view of inflation is coming from an overheating economy.

[Lisa Mateo]

You can get the news whenever you want it with Bloomberg News Now. I'm Amy Morris. And I'm Karen Moscow, here to tell you about our new on Demand news report delivered right to your podcast feed. Bloomberg News now is a short 5 minute audio report on the day's top stories. Episodes are published throughout the day with the latest information and data to keep you informed. Yes, there are other products like this.

[Emmy Nakamura]

From a variety of news organizations, but they usually rerun their radio newscasts throughout the day.

[Lisa Mateo]

That's not what we do. We create customized episodes that can only be heard on Bloomberg News now. And we don't wait an hour to publish breaking news. When news breaks, we'll have an episode up in your podcast feed within minutes. So you're always getting the latest stories and developments.

[Emmy Nakamura]

Get the reporting and the context from Bloomberg's 3000 journalists and analysts. We're all over the world. Listen to the latest from Bloomberg News now on Apple, Spotify or anywhere you listen.

[Joe Eisenthal]

Did the Fed do a good job?

[Tracy Alloway]

The paper reads like vindication.

[Joe Eisenthal]

Yeah, because I think in 2025 there's still plenty of fights about this question. What's your take?

[Emmy Nakamura]

I think so. We don't know what's going to happen going forward, but I think in the long span of history, if you look at what happened over the past five years, I think this is going to look like a soft landing and that is typically exactly what the Federal Reserve is trying to achieve. So I mean, obviously the Fed appropriately and private sector forecasters took a lot of flack for saying that inflation was going to be Very transitory when inflation was significantly more persistent. That said, inflation did come down very quickly and there hasn't been a recession. And that is remarkable. Not only has there not been a recession and not only did inflation come down very quickly, but longer term inflation expectations really did not become unhinged. Despite this historic increase in inflation, we haven't seen large increases in longer term bond yields. So this is all pretty remarkable. And I would think that if things go well over the next five years, that in the longer span of history, this is going to look like a big success.

[Tracy Alloway]

So this is where central bank independence and credibility actually comes into play when it comes to those longer term inflation expectations. How did you actually measure credibility in this paper? Because you don't look just at the Fed, you look at a bunch of other central banks.

[Emmy Nakamura]

Right. So when we look at other central banks, one of the things we point out is that there was a huge amount of variation in terms of how different central banks reacted to the COVID inflation. So we've been talking about the United States and similarly countries like Japan, the uk, the euro area. These countries all raised interest rates very gradually and by very moderate amounts relative to the size of the inflation increases they were facing. And so they all took a lot of flak for raising interest rates too slowly, for being behind the curve, for not raising interest rates enough. And these are the countries we refer to in our paper as late risers because they were late to the game. Right. But there were other countries in the world that we refer to as early risers who raised interest rates a lot more aggressively and a lot earlier. And the interesting observation, you might have thought that these countries would have suffered from the fact the late riser countries would have suffered from the fact that they were late to the game in raising interest rates with having higher inflation than the early risers who responded very aggressively. And in fact, we find the opposite. So the early risers did respond very aggressively to Covid inflation, but they actually saw inflation rise by a lot more during this episode. So then we asked the question, well, what could explain that? That seems sort of backwards. You have these countries that seem to have responded very aggressively with interest rates, and yet they saw the larger and more persistent inflationary surges. But then what we see is that those same countries are countries that have much more checkered inflation histories. So you asked about reputation. Well, a very simple way to ask about the reputation of a central bank for controlling inflation is just to look at average inflation in the recent decades. And so we look at average inflation over the previous three decades. And we see that the early riser countries, the ones that probably felt they had to respond very aggressively to the COVID inflation, also had much more checkered inflation histories. They had much higher average inflation over the past three decades previous to Covid. And so I think a natural interpretation of these facts is that for these countries, they did not feel that they had the inflation fighting credibility of the central banks in the United States or in Japan or in the euro area. They did not feel that they had the kind of strongly anchored inflation expectations that these countries could benefit from. And so for these countries, it really probably was not an option to think that they could look through inflation and yet keep inflation expectations anchored. But yet that is actually what happened happened in the United States and several other of these late riser countries.

[Joe Eisenthal]

So I find this to be really fascinating and I want to get to the question of whether the developed market or the US has ground down its stock of credibility over the last five years. But I want to, on this question of the early risers, I get what you're saying, but it's still not intuitive to me that the countries or the central banks with a sort of mediocre history of controlling inflation this time around were really on the ball in unison. I mean, I would think that if a central bank has a history of missing its inflation target or letting inflation rise, that at least some of them would have done it again. They would have come in late because that's what they do institutionally. How consistent is this process around the world whereby the countries that have a bad track record were early risers this time around?

[Emmy Nakamura]

Right. So we're not including every country. So there are some countries which are outliers in terms of their, in terms of their response in terms of their inflation. But I think one of the things you have to recognize is that in the world as a whole, there has been quite a remarkable sort of triumph of central banks over inflation. So back in the 1970s and 1980s, almost every country was like what we see in the early risers today. So none of these countries had really strong credentials as inflation fighters. And more recently, there are a number of these countries which are kind of moving in the direction of having much stronger inflation fighting credentials. But at the same time, these are countries where it's a relatively fresh history. So you look at some of these countries where they had pretty high inflation in the past, and they're just starting to be able to get over it. And then the question is, do you think that the public will be willing to watch you go through a period of, say, 10% inflation and say, oh, we're sure you're going to get it back to 2%, or do you think, you know, there's going to be a real question of whether you're going to be able to achieve that?

[Tracy Alloway]

Okay, so if on the other hand, you do have good credibility, you do have a good history of inflation fighting, then you can kind of spend that social capital, I guess, and avoid having to raise interest rates by as much as, you know, maybe another central bank that doesn't have that credibility. Walk us through, what exactly are the benefits of not having to do that.

[Emmy Nakamura]

Of not having to raise rates early rise? Absolutely. Well, you get closer to optimal monetary policy. So in the models, the basic idea is, for example, if you have one of these cost push shocks where there's a shock that is going directly to inflation because of increases in costs or bottlenecks of various types, or you have a shock during COVID to people's demand for goods versus services, if you raise the interest rate dramatically, like the Taylor rule might have predicted, you raised the interest rate to 10%. So what's going to have to happen to get inflation down to zero in the short run? Well, maybe you're going to have to have a big recession. You're going to have to have one part of the economy completely collapse. You know, Trump will tweet at you.

[Tracy Alloway]

More or post on Truth Social more.

[Emmy Nakamura]

Probably you're going to have to have really negative inflation in some sectors of the economy and you're going to have to have a big recession. And potentially the other issue is that there's a lot of evidence suggesting that monetary policy has pretty delayed effects. So another concern, and as I said in this episode, professional forecasters and the Fed both thought that the inflation would be more transitory than it actually was. But another concern is if you think that the shocks that are causing the inflation are sort of going to dissipate on their own, and you think the monetary policy has going to take some time to have an effect, then one of the concerns is that by the time the monetary policy actually has a large effect, then some of these shocks are going to dissipate. And then I guess the third thing I would mention is that in theory, the central bank actually wants to use a combination not only of current interest rate movements, but also a forward guidance. So this is one of the big innovations in monetary policy over recent decades. We think about forward guidance a lot in the context of the zero lower boundary. When you can't do anything with Fed funds rate. And so it's all about forward guidance. But actually forward guidance is a much, much more general phenomenon. It's really whenever the central bank is calling its shots about what it's going to do with interest rates, even over the next year. So this was hugely important during the COVID inflationary surge because the Fed started talking about raising interest rates and longer term bond yields started rising pretty rapidly in late 2021, substantially before the fed funds rate actually started to rise rapidly. And in the theory, a central bank that has that power, it has the ability to affect the economy not just through what it does with the fed funds rate, but also through its words and the impact on the bond market through that channel will actually want to use both. And so that's another advantage of not being bound by these kinds of constraints.

[Joe Eisenthal]

This strikes me as an incredibly important point, which is that you can tighten monetary policy by talking about it, by saying stuff. And so that just by looking at that overnight rate that the rule might anticipate, et cetera, does not necessarily capture the stance of monetary at that time if you're already indicated and you're pulling forward those rate hikes. So do we have less credibility today? So, okay, maybe the Fed did a good job in this time. Nonetheless, there was this very big inflationary episode, et cetera. So after years of very cool inflation, finally we got a big one going forward. Does that mean the next time around, if there is another inflationary shock for whatever reason, that the Fed might be impelled to be more of an early riser than it felt in this cycle?

[Emmy Nakamura]

I would think almost definitely, yes. Remember that going into the COVID inflation, you know, regular people hadn't seen significant amounts of inflation for years. It just wasn't really part of the mindset of anyone. When you saw, for example, unions in wage negotiations or other context things where inflation should have been relevant, it was sort of striking that it just wasn't on anyone's mind. And it even took a while after the inflation started for people to even think about this because it had become so much of a non issue for so many years that it was just not part of the mental frame of Americans. I see this very much when I teach students because for American students, typically I have to do a lot of work to just explain the difference, for example, between a nominal interest rate and a real interest rate.

[Tracy Alloway]

I did not earn interest on my bank account for most of my adult life. So I see that. Right, exactly.

[Emmy Nakamura]

But in contrast for Latin American students, they get it immediately because it's just part of how they grew up. Right. And I think that that distinction has probably blurred at least a little bit. Right. Because now people have gone through a few years where it mattered to pay a little bit of attention to infl. And so my guess is that if we start to see inflation again, it's going to be a much more rapid transition to where people will start to ask whether this is going to last longer, whether now that we've seen two inflationary episodes in the recent past, whether this is sort of the new normal. I think it's important not to forget how hard won those expectations of low inflation were for the Federal Reserve and many other countries. You know, it's certainly something that can dissipate.

[Tracy Alloway]

So because we're dealing with the Taylor rule, which basically, you know, suggests or describes either way what the central bank should do with interest rates in response to inflation and changes in the output gap, we're talking basically about like the impact of shocks to that output gap. There's a nuance here because like, shocks can be different and have different effects on the output gap. What type of shock would tariffs be? I know this isn't the subject of your paper, but you know, your gut instinct, how would you describe tariffs in terms of that economic shock and the impact on output?

[Emmy Nakamura]

So there have been a number of recent academic papers on this. It's not the focus of our paper, but I think that the overall message of those papers is that you do want to look through sort of the initial impact of the tariffs, but you don't want to look through sort of second round effect. So to the extent that you start to see an effect in terms of longer run inflation expectations becoming unhinged and so on, that's the part of the inflation that the central bank would want to be responding aggressively to.

[Lisa Mateo]

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[Joe Eisenthal]

I have another question that may be outside the scope of this specific paper.

[Tracy Alloway]

But it has a lot of relevance to today.

[Joe Eisenthal]

There's a lot. When you think about around the world, some central banks have more credibility and some others. Is it that the good central banks just had smarter, better economists do advising them better on policy than the other ones? Or does it have more to do with the political conditions that allow a central bank to operate separately from to essentially operate with independent agency? And is that more of a thing that originates in the political sphere of those countries?

[Emmy Nakamura]

I think clearly the politics is very important. I guess it would point to two things. One is those difficult decades of the 1970s and 1980s which occurred in many countries around the world and where people in these countries realized how much they hated inflation. We got a little bit of a taste of this during the COVID inflation. Inflation just is incredibly unpopular. And it was for this reason that it was possible in the United States to appoint Paul Volcker as chairman of the Fed, even though it was known before he was appointed what he was going to do, that he was going to raise interest rates aggressively, that this was going to be painful. And so that's a remarkable thing that it was actually possible to make this appointment. But of course similar things actually happened in other countries as well. There were similar appointments of aggressive central bankers that controlled inflation. So I think part of this did come out of sort of a public reaction to inflation. But at the same time it didn't happen everywhere, just like you said, and could only happen in the context of political protection for the central bank, central bank independence. And perhaps in some ways it's just sort of a remarkable thing that it ever did happen that we've seen this long period of low inflation in many of these countries.

[Joe Eisenthal]

I simply realized I've heard over the years at various times where deviations from the Taylor rule, whether it was the zero lower bound era where we couldn't lower them, or more recently, how far were they off in the 70s when inflation was going crazy? Is there a good measure of like. No, clearly they should have been higher. There's like what does the Taylor rule say about that?

[Emmy Nakamura]

The 1970s? Very interesting because one of the things we point out in our paper is that the predictions and the prescriptions of the Taylor rule are of course only as good as the inputs. You put into them. And one of the things that some of the academic literature has pointed out is that you don't necessarily want to use the data that we have today on something like the output gap, because views about the output gap, that is how overheating is the economy, have changed over time. And in particular, in the 1970s, the Federal Reserve was pretty optimistic about the potential output of the US Economy. And for that reason, its judgment about the output gap was pretty negative. And this helps to explain, through the lens of the Taylor Rule, why they had pretty dovish monetary policy in the 1970s. So actually, if you take the real time data on what the Fed said it thought the output gap was at the time, along with inflation, then you get more or less what they did and what happened in terms of why many people think that the policy was too dovish in the 1970s has a lot to do whether you think those measures of the output gap were reasonable and the current estimates according to the Fed are much less dovish than they were at the time. But it highlights the fact that even when you want to create a rule which is sort of very technocratic and doesn't give you any wiggle room, that's not entirely true, because something like the output gap is not something that you can just read off a statistic like inflation. Actually, you can. And so as a consequence, you know, it really matters what judgment you take about where you are relative to the economy's potential.

[Joe Eisenthal]

You can never escape human. You never quite escape human judgment.

[Emmy Nakamura]

Unfortunately.

[Tracy Alloway]

I remember that the output gap debate was a big thing after 2008 as well. Okay, just going back to the idea of this technocratic rule, whether it's prescriptive or descriptive, I know people have different opinions on that, but supposedly one of the benefits of it being possibly prescriptive was that you have a central bank that, like, does a very expected thing, like, you know what the reaction function is and you know what they're going to do in response to inflation. How does that play into the credibility aspect? Because on the other hand, more credible central banks, they can kind of go off and do their own thing, go beyond the Taylor Rule, as you put it in the paper. But on the other hand, does that unexpected behavior perhaps have an impact on their own credibility, even if it's successful in the short term?

[Emmy Nakamura]

Absolutely. I mean, I think that technocratic rules, like the Taylor rule, they absolutely have a place in the canon of monetary policy. And perhaps one could even argue that they should be the default in response to many kinds of inflationary Episodes, because there are many kinds of inflationary episodes like those associated with excessive demand, an overheating economy, and also even worse, just sort of self fulfilling worries about inflation that spiral off into really serious inflationary episodes. So in response to all of those kinds of episodes, it may be a very good idea for people to be able to expect that central bank is going to respond aggressively along the lines of something like the Taylor rule. And there's a sense in which you might want to think about going beyond the Taylor rule as something that you don't do all the time, but that you recognize has to happen some of the time when you have a strong sense that a different kind of shock is hitting the economy. And in some of those episodes you might actually want to very explicitly use forward guidance. So for example, during the Great Recession, that was a period when there was some of the most explicit usage of forward guidance to talk about the timing of how long the Fed was going to keep interest rates at zero. And that was a very powerful tool in terms of affecting longer term interest rates. It's very easy to see that in the data. And that's the kind of thing where it's not about going away from reputation, which it's true. That core idea is that you want markets to absolutely be confident that the central bank is going to respond aggressively to any sense of de anchoring of inflation expectations. And that is very important. But at times you may want to use forward guidance in other ways. And the response of the Fed to the Great Recession is an example of that.

[Joe Eisenthal]

I just have one last question and it's kind of selfish. So you're talking about different sources of inflation, whether it's excess demand or whether it's supply. Tracy and I did a ton of podcast episodes in 2021, 2022 about supply chains. We talked about the ports and all of this stuff that you know. But someone could say you guys were missing the forest for the trees. The stress at the ports wasn't about supply chains. It was because there was too much demand. The stress at the X factory wasn't because of some supply chain or missing part. There was just too much demand. You guys were just disguising demand problems by focusing on choke points that are inevitably going to emerge when booming demand. I still think about this. I'm like, oh, should we have focused some? But you have described a lot of this inflation. And part of the reason for the immaculate disinflation is because a lot of it was supply defense. I'm looking for a defense of all this focus that we did on the supply side.

[Emmy Nakamura]

So I think you're right that there's kind of a false dichotomy between talking about demand shocks and things like supply constraints like the ports and the Suez Canal and so on. Because you're right that if you have too much demand, then at some point these supply chains get clogged. And so it's absolutely right that those kinds of supply constraints are not quite the same as supply shocks. Right. But there are other things which are just directly shocked.

[Joe Eisenthal]

The war in Ukraine was a shock.

[Emmy Nakamura]

Exactly. And Covid, for example, generated all sorts of sort of negative productivity throughout the economy that just made things more expensive to produce in a variety of ways. So these are some of the things that I think are genuinely basically negative productivity shocks which were sort of hard to find examples of previous to Covid, but easy to find examples of during.

[Tracy Alloway]

COVID How good are policymakers at identifying types of shocks in real time?

[Emmy Nakamura]

That is a very important question. And you know, I think my discussion of the 1970s and the fact that, you know, views have changed over time about the output gap during that period and also during the COVID inflation, you know, views of change shows that this is by no means, means perfect. But at the same time, I think there are times when there's a strong sense that the COVID inflation, for example, wasn't just about self fulfilling inflation expectations or something like this. And so that's where I want to emphasize this idea that there's a difference between saying that we can always identify the shocks with confidence, which clearly we cannot, and saying that we can never identify any shocks to the extent that we need to tie ourselves all the time to a mechanical rule which, you know, may deviate from, from what theory really says is optimal monetary policy. But again, you know, I think crucial ideas is all of this has to take place against a background where there's sort of confidence in the central bank's commitment to longer run inflation stability.

[Tracy Alloway]

All right, Emmy Nakamura, thank you so much. This was a real treat for us. I kind of want to go to Berkeley now.

[Joe Eisenthal]

Yeah, I know. I do too. That was amazing. Thank you so much. That was fantastic.

[Emmy Nakamura]

Thank you.

[Tracy Alloway]

That was great, Joe, that was fantastic. I really enjoyed that conversation. And Emmy has a remarkable way of explaining like some complicated concepts very simply and in a real understandable way. Because if you flip through her paper, there's a lot of formulas and things like that. So it looks complicated, but she explained.

[Joe Eisenthal]

It very clearly, incredibly clearly. I had the same thought. I was like, oh man, it would be so nice to just be like a student and get to being a student. Sounds very fun, but incredibly clear. And she's one of the foremost inflation experts in academia. And so to hear her sort of, sort of summation of how she thinks about the last five years and the lessons learned from it was like a real treat.

[Tracy Alloway]

Yeah. And obviously there are a couple takeaways there. So one, it is incredibly hard for policy, or often incredibly hard for policymakers to identify shocks, you know, at the moment that they're happening, but sometimes they can, like in Covid. And I guess the second takeaway is the importance of credibility. Right. And if you, if you manage to successfully control inflation for years and years and decades or whatever, you build up that social capital, which then allows you to be somewhat more flexible when you have another crisis.

[Joe Eisenthal]

Yeah, I thought that was really interesting. Also, there are a couple other things that struck me. First of all, until reading this paper, and this is just my fault because I could look this up at any time, I had not realized that the Taylor Rule was built up six years of data. There's like, okay, this is the rule that describes when a central bank is.

[Tracy Alloway]

Doing all of monetary policy. Basically.

[Joe Eisenthal]

This is the rule that sort of describes what a well functioning central bank looks like is basically six years. That's interesting to me too. And second of all, this idea that even though it does look like a hard rule, that you can't escape the fact that you have to judge the output gap. And there were very big debates about the size of the output gap after 2008 and 2009, very sharp disagreements about the capacity or what full employment looked like. So even that doesn't fully solve you, even if you do tie yourself to the lash of a hard rule or lash yourself to the mast of a hard rule. Tough problem still.

[Tracy Alloway]

Yeah, it's tough. All right, shall we leave it there?

[Joe Eisenthal]

Let's leave it there.

[Tracy Alloway]

This has been another episode of the Odd Lots podcast. I'm Tracy Alloway. You can follow me at Tracy Alloway.

[Joe Eisenthal]

And I'm Jill Wiesenthal. You can follow me at the Stalwart. If you want to read Emmy's paper, go check out the Kansas City Fed's website. Follow our producers, Carmen Rodriguez, Ermenarmon, Dashiell Bennett at dashbot and Cale Brooks at Kalebrooks. For more Odd Lots content, go to bloomberg.com oddlots where we have a daily newsletter and all of our episodes. And you can chat about all of these topics 24. 7 In our Discord Discord, GG Oddlauts.

[Tracy Alloway]

And if you enjoy odd lots. If you like it when we go to Jackson Jackson Hole to interview prominent economists, then please leave us a positive review on your favorite podcast platform. And remember, if you are a Bloomberg subscriber, you can listen to all of our episodes absolutely ad free. All you need to do is find the Bloomberg Channel on Apple Podcast and follow the instructions there. Thanks for listening.

[Emmy Nakamura]

Sam.