Kevin Lee, James Morley and Kalvinder Shields
Economists frequently refer to the “Taylor rule” when interpreting interest rate movements arising from monetary policy. This is a simple rule suggested by John B. Taylor, which links the interest rate set by a central bank to just two factors: namely, inflation and the extent to which output is above or below trend. Analysts estimate Taylor rules not to expose a rule that was actually used in formulating policy but to understand the systematic reaction of monetary policy to economic conditions. But, of course, there have been considerable changes over the decades in policy-makers’ perceived payoffs from policy interventions and this translates into changes in policy regime, sometimes occurring abruptly with the appointment of a new central bank chair and sometimes involving an evolution of policy as priorities and beliefs change. This potential for structural instability generates difficulties in measuring the systematic links between interest rates, inflation and output.
In this Nottingham School of Economics working paper, in the Journal of Money, Credit and Banking, Kevin Lee and co-authors provide a characterisation of U.S. monetary policy based on a novel modelling approach. This accommodates regime change by using a set of Taylor rules obtained on different data samples, averaging over the different rules with weights that change over time to obtain a single ‘meta’ rule. We apply the method to U.S. data and the estimated rule provides a simple and compelling characterisation of monetary policy over the last forty years. The rule highlights the lack of feedback from inflation to monetary policy during the early-to-mid seventies, the change in direction when Miller became Federal Reserve Chair, and the strong feedback from inflation and output to interest rates during the Volcker/early-Greenspan years. The rule also provides evidence of changes in the emphasis on inflation and on output subsequently, illustrating the successive effects of the fear of overheating, an easing on inflation, a re-assertion of anti-inflationary policies and the dramatic impact of the financial crisis on policy. We also found that the Federal Reserve cares more about the immediate future than longer horizons during periods of recession.
Journal of Money, Credit and Banking, “The Meta Taylor Rule” by Kevin Lee, James Morley and Kalvinder Shields.
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Posted on Wednesday 22nd July 2015