Alex Nikolsko-Rzhevskyy's Work on Quantitative Easing Features in Industry Debates

For release:  May 12, 2011

Prof. Alex Nikolsko-Rzhevskyy's recent working paper Taylor's Rule versus Taylor Rules, with Prof. David Papell from the University of Houston, is discussed in both Economics One and Econbrowser blogs and contributes to today's policy debate on quantitative easing (QE). 

The rationale for both rounds of quantitative easing since 2009 is that the desired, or prescribed, federal funds interest rate is negative. Since the Fed cannot lower interest rates below zero, additional stimulus is warranted. The most common benchmark for the prescribed interest rate is the Taylor rule. In its original form, the Taylor rule states that the federal funds rate should equal 1.0 + 1.5 times the inflation rate + 0.5 times the output gap, the percentage deviation of GDP from long-term potential GDP, and it implies a positive interest rate. Proponents of QE II use a higher coefficient on output (around 1.0, rather than 0.5) which results in a much lower, negative interest rate. 

The paper analyzes Fed policy following the recessions of the 1970s and the 1990s and uses the results to evaluate Fed policy in the 2000s. The advantage of this approach is that, since there is widespread agreement that Fed policy was too stimulative in the 1970s and on target in the 1990s, it becomes possible to analyze different variants of Taylor rules in relation to a non-controversial benchmark. 

The results show that Taylor's original rule, which can be justified by historical experience, does not produce negative prescribed interest rates for 2009-2011 and thus does not provide a rationale for quantitative easing I or II. Variants of Taylor rules with larger output gap coefficients, which do produce negative interest rates, cannot be justified by historical experience and would potentially lead to inferior economic performance.