# Taylor rule’s influence on policy

However, the actual fact that the Taylor rule has been described in the policy meetings will not necessarily imply it has had a substantial influence on the decisions. One method to analyse the need for the Taylor rule is merely to consider the correlation between your original Taylor rule and the actual Federal Fund’s Rate. Predicated on this process, Taylor (2012) argues that the Fed followed the Taylor rule quite closely until around 2003. From then on, he argues that the Fed abandoned the Taylor rule around 2003 and moved to a far more discretionary monetary policy. Some observers start to see the large deviation from the Taylor rule between 2003 and 2006 as an insurance plan mistake that contributed to the build-up of financial imbalances and the next crisis.

Rather than simply comparing the initial Taylor rule with the actual interest, another common approach is to estimate more general specifications of the Taylor rule; for instance, by like the lagged interest and forward-looking terms. Clarida, Galì and Gertler (2000) showed that the Fed’s policy through 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 before the financial meltdown by showing a forward-looking Taylor rule could have implied mortgage loan nearer to the actual one. However, the actual fact that monetary policy could be represented by around or calibrated interest rule does not indicate that the central bank follows a rule-based policy. A purely discretionary policy could be characterised by mortgage loan ‘rule’. As demonstrated by Jensen (2011), you need to be cautious when interpreting estimated interest rules, both as proof rule-based behaviour so when investigating equilibrium determinacy.

# Guidelines not rules

Carrying out a simple policy rule mechanically is both unrealistic and undesirable. This aspect can be recognised by proponents of rule-based policy, who advise that you need to deviate from the rule when you have information that justifies deviations. The premise a rule ought to be a guideline – rather than a straitjacket – begs the question, what exactly are the justifications for deviating from the rule? Obviously, this depends upon this shocks that are hitting the economy. Unless the intercept term in the Taylor rule is continually adjusted, the Taylor rule will give inefficient stabilisation of output and inflation whenever there are changes in the natural interest, as the Taylor rule will neglect 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 may be perfect for supply shocks, but a larger weight on the output gap will be better fitted to demand shocks.

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

An alternative solution to describing monetary policy regarding a simple interest rule is ‘optimal policy’. Svensson (2003) argues that it’s actually more consistent and realistic to take care of monetary policymakers as any other agents throughout the market, i.e., by specifying preferences (a loss function) and constraints (the model) and by let’s assume that the policymakers act optimally at the mercy of their information. Comparing the empirical fit of both approaches – simple rules versus optimal policy – Ilbas (2012) finds that optimal policy does indeed describe the behaviour of the Federal Reserve much better than simple rules do. However, remember that Adolfson et al. (2011) find a simple rule includes 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 focus on simple rules. To measure the importance positioned on the Taylor rule by the Fed, also to analyse if the period after 2003 represented a shift from it, we introduce an insurance plan preference function which includes a weight on the Taylor rule. We therefore assume that, as well as the commonly used (random) loss function, the policymaker dislikes deviations of the interest from the Taylor rule.

Our approach is inspired by Rogoff’s (1985) seminal paper on the perfect amount of commitment to an intermediate target, where he argues that "it isn’t generally optimal to legally constrain the central bank going to 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 process seems in keeping with how policymakers form their interest-rate decisions used. For instance, Vice Chair Janet Yellen (2012) formulates the role of the Taylor rule in monetary-policy assessments the following:

"One approach I find helpful in judging a proper path for policy is founded on optimal control techniques… An alternative solution approach that I find helpful… is to consult prescriptions from simple policy rules. Research shows that these rules succeed in a number of models and tend to be robust compared to the optimal control policy produced from any single macroeconomic model".

Considering that policymakers utilize both (explicit or implicit) optimal policy and simple rules, our modified loss function offers a unified approach for analysing monetary-policy decisions. A virtue of the approach is that one may analyse whether actual deviations from the Taylor rule represent optimal deviations for confirmed weight, or a reduction in the weight positioned on the rule.

# Conclusions

We find that the model with losing function that includes the initial Taylor rule includes a better empirical fit compared to the model with the typical 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 didn’t decrease in the time after 2003, unlike what Taylor (2012) argues. When decomposing the many shocks hitting the united states economy, we find that in the time 2001 – 2006, large negative demand-side shocks were dominating. As noted above, this can be the type of disturbances which should make policymakers deviate from the Taylor rule. Indeed, the perfect policy response to these shocks implied a straight lower interest rate compared to the actual Fed Funds Rate. We thus find that in the time 2001 – 2006 the Fed conducted a far more contractionary policy than what will be implied by their historical reaction pattern.

# References

Adolfson, M, Laséen, S, Lindé, J and Svensson, L E O, (2011), “Optimal Monetary Policy within 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 plus some Theory”, The Quarterly Journal of Economics, 115(1), 147-180.

Ilbas, P (2012), “Revealing the Preferences of the united states 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 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 PERFECT Amount 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’s 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 used”, Carnegie-Rochester Conference Series on Public Policy, 39, 195-214.

Taylor, J B (2012), “Monetary Policy Rules Work and Discretion Doesn’t: AN ACCOUNT 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.