The influence of the Taylor rule on US monetary policy

Pelin Ilbas, Øistein Røisland, Tommy Sveen, 13 February 2013

a

A

The Taylor rule has undoubtedly influenced the debate about monetary policy over the last 20 years. But has it directly influenced monetary policy? According to a survey by Kahn (2012), the answer seems to be that it has. The transcripts from the Federal Open Market Committee meetings include several references to the rule. For example, at the Federal Open Market Committee meeting on January 31 - February 1, 1995, the Greenbook suggested a 150 basis points increase of the Federal funds rate to 7%; in response, Federal Open Market Committee member Janet Yellen expressed concern, "I do not disagree with the Greenbook strategy. But the Taylor rule and other rules … call for a rate in the 5% range, which is where we already are. Therefore, I am not imagining another 150 basis points".

Taylor rule’s influence on policy

However, the fact that the Taylor rule has been referred to in the policy meetings does not necessarily imply that it has had a significant influence on the decisions. One way to analyse the importance of the Taylor rule is simply to consider the correlation between the original Taylor rule and the actual Federal Fund's Rate. Based on this approach, Taylor (2012) argues that the Fed followed the Taylor rule quite closely until around 2003. After that, he argues that the Fed abandoned the Taylor rule around 2003 and moved to a more discretionary monetary policy. Some observers see the large deviation from the Taylor rule between 2003 and 2006 as a policy mistake that contributed to the build-up of financial imbalances and the subsequent crisis.

Instead of simply comparing the original Taylor rule with the actual interest rate, another common approach is to estimate more general specifications of the Taylor rule; for example, by including the lagged interest rate and forward-looking terms. Clarida, Galì and Gertler (2000) showed that the Fed's policy during the Volcker-Greenspan period is represented by a forward-looking Taylor rule. Indeed, Bernanke (2010) replied to Taylor's critique about the large deviations from the Taylor rule prior to the financial crisis by showing that a forward-looking Taylor rule would have implied an interest rate closer to the actual one. However, the fact that monetary policy can be represented by an estimated or calibrated interest rate rule does not necessarily mean that the central bank follows a rule-based policy. A purely discretionary policy can be characterised by an interest rate ‘rule’. As demonstrated by Jensen (2011), one should be careful when interpreting estimated interest rate rules, both as evidence of rule-based behaviour and when investigating equilibrium determinacy.

Guidelines not rules

Following a simple policy rule mechanically is both unrealistic and undesirable. This point is also recognised by proponents of rule-based policy, who recommend that one should deviate from the rule when one has information that justifies deviations. The premise that a rule should be a guideline – and not a straitjacket – begs the question, what are the justifications for deviating from the rule? Obviously, this depends on the particular shocks that are hitting the economy. Unless the intercept term in the Taylor rule is constantly adjusted, the Taylor rule tends to give inefficient stabilisation of output and inflation when there are changes in the natural rate of interest, as the Taylor rule will then fail to close the output gap in the short run (see Woodford 2001). The inefficiency of the Taylor rule under certain shocks was also noted by the Fed staff, who – according to Federal Open Market Committee transcripts from November 1995 – argued that the Taylor rule might be well suited for supply shocks, but a greater weight on the output gap would be better suited for demand shocks.

Since appropriate deviations from the Taylor rule depend on the type and size of shocks, one cannot necessarily conclude that a period of large deviations, such as in 2003-05, reflect less weight on the rule for policy decisions. An alternative explanation is that specific shocks justified larger deviations from the Taylor rule for a given weight.

An alternative to describing monetary policy in terms of a simple interest rate rule is ‘optimal policy’. Svensson (2003) argues that it is in fact more consistent and realistic to treat monetary policymakers as any other agents in the economy, i.e., by specifying preferences (a loss function) and constraints (the model) and by assuming that the policymakers act optimally subject to their information. Comparing the empirical fit of the two approaches – simple rules versus optimal policy – Ilbas (2012) finds that optimal policy does indeed describe the behaviour of the Federal Reserve better than simple rules do. However, note that Adolfson et al. (2011) find that a simple rule has a slightly better empirical fit for the policy of the Swedish Riksbank.

New research

In recent work (Ilbas, Røisland and Sveen, 2013), we show that the empirical fit of optimal policy increases if one allows policymakers to pay attention to simple rules. To assess the importance placed on the Taylor rule by the Fed, and to analyse whether the period after 2003 represented a shift away from it, we introduce a policy preference function that includes a weight on the Taylor rule. We therefore assume that, in addition to the commonly used (ad hoc) loss function, the policymaker dislikes deviations of the interest rate from the Taylor rule.

Our approach is inspired by Rogoff's (1985) seminal paper on the optimal degree of commitment to an intermediate target, in which he argues that "it is not generally optimal to legally constrain the central bank to hit its intermediate target (or follow its rule) exactly" (1169). Our modified loss function can either be interpreted as optimal policy with cross-checking by the Taylor rule or as optimal deviations from a Taylor rule. This approach seems consistent with how policymakers form their interest-rate decisions in practice. For example, Vice Chair Janet Yellen (2012) formulates the role of the Taylor rule in monetary-policy assessments as follows:

"One approach I find helpful in judging an appropriate path for policy is based on optimal control techniques… An alternative approach that I find helpful… is to consult prescriptions from simple policy rules. Research suggests that these rules perform well in a variety of models and tend to be more robust than the optimal control policy derived from any single macroeconomic model".

Given that policymakers make use of both (explicit or implicit) optimal policy and simple rules, our modified loss function provides a unified approach for analysing monetary-policy decisions. A virtue of this approach is that one can analyse whether actual deviations from the Taylor rule represent optimal deviations for a given weight, or a decrease in the weight placed on the rule.

Conclusions

We find that the model with the loss function that includes the original Taylor rule has a better empirical fit than the model with the standard loss function. Our result therefore confirms the indirect evidence in Kahn (2012) on the influence of the Taylor rule on the Federal Open Market Committee's policy decisions. Moreover, we find that the weight on the Taylor rule did not decrease in the period after 2003, contrary to what Taylor (2012) argues. When decomposing the various shocks hitting the US economy, we find that in the period 2001 - 2006, large negative demand-side shocks were dominating. As noted above, this is the type of disturbances that should make policymakers deviate from the Taylor rule. Indeed, the optimal policy response to these shocks implied an even lower interest rate than the actual Fed Funds Rate. We thus find that in the period 2001 - 2006 the Fed conducted a more contractionary policy than what would be implied by their historical reaction pattern.

References

Adolfson, M, Laséen, S, Lindé, J and Svensson, L E O, (2011), “Optimal Monetary Policy in an Operational Medium-Sized DSGE Model”, Journal of Money, Credit and Banking, 43, 1287-1331.

Bernanke B S, (2010), “Monetary Policy and the Housing Bubble”, Speech at the Annual Meeting of the American Economic Association.

Clarida R, Galí J, Gertler M (2000), “Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory”, The Quarterly Journal of Economics, 115(1), 147-180.

Ilbas, P (2012), “Revealing the Preferences of the US Federal Reserve”, Journal of Applied Econometrics, 27, 440-473.

Ilbas, P, Røisland, Ø, Sveen, T (2013), “The Influence of the Taylor Rule on US Monetary Policy”, Norges Bank working paper 2013/04 and NBB working paper 241.

Jensen, H (2011), “Estimated Interest Rate Rules: Do they Determine Determinacy Properties?”, The B E Journal of Macroeconomics, 11(1).

Kahn, G A (2012), “The Taylor rule and the practice of central banking”, in Koenig, E F, Leeson, R and Kahn, G A (eds.) The Taylor rule and the transformation of monetary policy, California, Hoover Institution Press, Stanford University.

Rogoff K (1985), “The Optimal Degree of Commitment to an Intermediate Monetary Target”, The Quarterly Journal of Economics, 100(4), 1169-1189.

Smets F, Wouters R (2007), “Shocks and Frictions in US Business Cycles: A Bayesian DSGE Approach”, The American Economic Review, 97, 586-606.

Svensson, L E O (2003). “What is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules”, Journal of Economic Literature, 41, 426-477.

Taylor, J B (1993), “Discretion versus Policy Rules in Practice”, Carnegie-Rochester Conference Series on Public Policy, 39, 195-214.

Taylor, J B (2012), “Monetary Policy Rules Work and Discretion Doesn't: A Tale of Two Eras”, Journal of Money Credit and Banking, 44(6), 1017-1032.

Woodford, M (2001), “The Taylor Rule and Optimal Monetary Policy”, The American Economic Review, 91(2), 232-237.

Yellen, J L (2012), “The Economic Outlook and Monetary Policy”, speech given at the Money Marketeers of New York University, New York, April 11, available at http://www.federalreserve.gov/newsevents/speech/yellen20120411a.htm.

Topics: Monetary policy
Tags: Fed, Federal Reserve, Taylor rule, US

Research economist, National Bank of Belgium

Research Director at Norges Bank

Professor of Macroeconomics at BI Norwegian Business School