July 24 (Bloomberg) -- John Taylor has a message for economists who say Ben S. Bernanke is ignoring a benchmark guide for interest rates: They’re wrong.

Taylor should know: He wrote the rule.

Economists from Goldman Sachs Group Inc., Macroeconomic Advisers LLC, Deutsche Bank Securities Inc. and even the San Francisco Federal Reserve Bank argue the Taylor Rule, a pointer for finding the correct level for interest rates, suggests the Fed should be doing a lot more to stimulate the economy.

Taylor said his measure shows just the opposite: that Fed policy is appropriate, that central bankers are right to be considering how to withdraw their unprecedented monetary stimulus and that critics who say otherwise are misinterpreting his rule. The formula is designed to show the best rate for spurring growth without stoking inflation.

“They say they’re using the Taylor Rule, but they’re not,” Taylor, an economist at Stanford University in Stanford, California, said in an interview. “My rule does suggest a long time before we raise rates. But it also does suggest an earlier rate increase than you would think.”

At stake in the debate: Whether the central bank can steer a course that avoids repeating past policy errors. In 1936, policy makers prolonged the Depression by raising borrowing costs before a recovery was entrenched. In the 1970s, inflation soared when they held off on rate increases.

Inflation Slows

Inflation, using the government’s personal consumption expenditures price index, slowed to a 0.1 percent annual pace in May from 2.6 percent in September 2007, when Chairman Bernanke, 55, and his colleagues started their campaign of 10 cuts in the benchmark rate, to a range of zero to 0.25 percent.

A jump in measures of expected inflation has reinforced concern among some analysts that the central bank needs to cement plans for withdrawing its stimulus. The spread between yields on 10-year Treasuries and 10-year Treasury Inflation- Protected Securities -- a gauge of the average increase in consumer prices over that period -- has widened to 1.91 percentage point from 0.09 percentage point at the start of the year.

“The Fed is caught in a bind right now,” said Robert Eisenbeis, a former research director at the Atlanta Fed who’s now chief monetary economist at Cumberland Advisors in Vineland, New Jersey. “The Taylor Rule sort of defines the policy problem. The debate centers around what the exit strategy is and how quickly it will be executed.”

Bernanke Praise

In 2007, Bernanke praised the Taylor Rule as providing “essential guidance” on setting interest rates. Fed staffers provide Taylor Rule estimates to policy makers before each of the Fed’s Open Market Committee meetings.

Taylor’s formula says the Fed’s main target interest rate should be 1.5 times the inflation rate, plus 0.5 times the gap between the economy’s potential growth rate and the current pace, plus 1. Taylor, 62, who served under President George W. Bush as a Treasury undersecretary, published the rule in a paper for a 1992 conference when at Stanford.

One main inflation indicator Fed officials use to monitor price pressures, the personal consumption price index, rose 0.8 percent in the first quarter from a year earlier. In the same period, the so-called output gap, as measured by the Congressional Budget Office, showed a shortfall of 6.31 percentage points.

Alternative Strategy

Those figures suggest the federal funds rate target should actually be negative 0.955 percent. Since the Fed can’t lower rates to less than zero, the Taylor rule means the central bank has to pump money into the economy through other methods, such as purchases of Treasuries, mortgage securities and agency bonds.

That’s exactly what the Fed under Bernanke has been doing, more than doubling assets on its balance sheet to $2 trillion. The debate among economists is whether they’ve done enough to meet the Taylor formula.

The Fed’s record-low rate allows banks to earn a higher spread on their loans as they pay less for deposits compared with the rates they charge for longer-term credit.

New York-based Goldman Sachs and JPMorgan Chase & Co. are among financial firms that this month reported bigger profits for the second quarter, underscoring signs that the crisis is easing. Goldman Sachs July 14 said it had record net income of $3.44 billion in the period. JPMorgan, the second-biggest U.S. bank, posted $2.72 billion in earnings two days later.

Greenspan Comparison

Bernanke’s predecessor, Alan Greenspan, held the federal funds rate below the Taylor rule standard from 2001 until he left office in 2006, according to calculations by Deutsche Bank AG and Stone & McCarthy Research Associates. Their models indicate that even with rates effectively at zero, Bernanke is providing less stimulus than Greenspan did, even in a period of deeper recession and higher unemployment.

Macroeconomic Advisers said its growth and inflation forecasts for the coming year show the Fed should be aiming for the equivalent of a negative 4 percent federal funds rate under the Taylor rule.

“What’s been done so far is not enough to get the economy back to any reasonable growth rate,” said Laurence Meyer, 65, a former Fed governor who is vice chairman of Macroeconomic Advisers. “You need to use your balance-sheet policies sufficiently aggressively to replicate the effect you would have had if you pushed the funds rate down to negative numbers.”

Negative 5%

At the San Francisco Fed, researchers did similar calculations and found the Taylor rule would call for the equivalent of a negative 5 percent funds rate by the end of this year.

San Francisco Fed President Janet Yellen, 62, said she is worried about the parallel to 1936. “We should want to do more,” Yellen said June 30. “If we were not at zero, we would be lowering the funds rate.”

Jan Hatzius, the chief U.S. economist at Goldman Sachs in New York, is particularly pessimistic. His projections show policy makers should plan for policies equivalent to a federal funds rate of negative 5.8 percent this year, and about negative 9 percent by December 2010.

“They are not following the Taylor rule at the moment,” Hatzius said. “If they were, they’d be more aggressive.”

Taylor’s admonishing Hatzius and other critics recalls Woody Allen, in his 1977 movie “Annie Hall,” calling forth philosopher Marshall McLuhan on a movie line to deflate a tweedy academic pontificating about McLuhan by telling him that “you know nothing of my work!”

Credit Costs

Former Fed Vice Chairman Alan Blinder, who has argued inflation is not a major concern at the moment, said he’s not joining in the debate over the Taylor rule. What’s important, he said, is that the spread between the federal funds rate and consumer and business borrowing costs has come down in recent months as the credit crisis has eased.

“As spreads have narrowed in recent months, monetary policy has automatically become more expansionary, even at an unchanged funds rate,” said Blinder, 63.

The average premium on loans to buy new cars over the benchmark one-month London interbank offered rate for the dollar dropped to 3.16 percentage points in June from 7.98 percentage points in December. The average spread between 30-year fixed- rate mortgages and 10-year Treasury notes narrowed to 1.86 percentage point from 3.05 percentage point in the same period.

Taylor himself said there’s evidence the Fed is correctly applying his formula. He said that economists who call for negative interest rates are using projections to apply the rule in ways he never intended.

Taylor’s Codicil

“The Taylor rule says what the interest rate should be now, given current numbers,” not forecasts, he said.

The latest data show the contraction easing, which should reduce the output gap, Taylor said. He points to fed federal funds futures, which project a target rate of 0.5 percent by February and 1 percent by a year from now.

“It’s not clear the Fed has a long time before it has to raise rates,” Taylor said. “The markets are already calling for a rate increase early next year.”

Some economists have also tweaked the original Taylor rule, said Peter Hooper, a former Fed economist who’s now chief economist at Deutsche Bank Securities in New York.

“There are a number of Deutsche Bank models,” he said, adding that applying the Taylor Rule is particularly difficult in the current economic environment. “I would take it with a grain of salt.”

Joachim Fels, co-head of global economics at Morgan Stanley in London, agrees. “It’s a nice concept, but it very much depends on where you believe the output gap is,” Fels said. “Ask any two economists what the number is and you get three answers.”

The U.S. central bank should rely on its own discretion in setting rates, and not on a rule, Fels said.

“Depending on the inputs,” he said, “I could justify any short rate at the moment with some Taylor rule.”

To contact the reporter on this story: Michael McKee in New York at mmckee@bloomberg.net.

Last Updated: July 24, 2009 15:36 EDT