Working Papers

Taylor Rules and the Great Inflation: Lessons from the 1970s for the Road Ahead for the Fed

 

(with Alex Nikolsko-Rzhevskyy)

 

Can U.S. monetary policy in the 1970s be described by a stabilizing Taylor rule with a two percent inflation target when policy is evaluated with real-time inflation and output gap data? If so, it is problematic to use the Taylor rule as a guide to good policy as the Federal Reserve implements its exit strategy from the extraordinary measures taken in 2008 and 2009 since the same policy produced the Great Inflation. Using economic research on the full employment level of unemployment and the natural rate of unemployment published between 1970 and 1977 to construct real-time output gap measures for the periods of peak unemployment, we find that the Federal Reserve did not follow a Taylor rule if appropriate measures are used. We estimate Taylor rules and find no evidence that monetary policy stabilized inflation, even allowing for changes in the inflation target. While monetary policy was stabilizing with respect to inflation forecasts, the forecasts systematically under-predicted inflation following the 1970s recessions and this does not constitute evidence of stabilizing policy. We also find that the Federal Reserve responded too strongly to negative output gaps. If the Federal Reserve stabilizes inflation and does not respond too strongly to the output gap as the recovery begins, the 2010s can be a period of good economic performance like the 1980s and 1990s rather than a repeat of the 1970s. (September 2009)

 

Taylor Rules and the Euro

 

(with Tanya Molodtsova and Alex Nikolsko-Rzhevskyy)

 

This paper uses real-time data to show that inflation and either the output gap or unemployment, the variables which normally enter central banks’ Taylor rules for interest-rate-setting, can provide evidence of out-of-sample predictability and forecasting ability for the United States Dollar/Euro exchange rate from the inception of the Euro in 1999 to the end of 2007. We also present less formal evidence that, with real-time data, the Taylor rule provides a better description of ECB than of Fed policy during this period. The strongest evidence is found for specifications that neither incorporate interest rate smoothing nor include the real exchange rate in the forecasting regression, and the results are robust to whether or not the coefficients on inflation and the real economic activity measure are constrained to be the same for the U.S. and the Euro Area. The evidence is stronger with inflation forecasts than with inflation rates and with real-time data than with revised data. Bad news about inflation and good news about real economic activity both lead to out-of-sample predictability and forecasting ability through forecasted exchange rate appreciation. (July 2009)

 

Inflation Persistence and the Taylor Principle

 

(with Chris Murray and Alex Nikolsko-Rzhevskyy)

 

Although the persistence of inflation is a central concern of macroeconomics, there is no consensus regarding whether or not inflation is stationary or has a unit root. In the context of a “textbook” macroeconomic model, inflation is stationary if and only if the Taylor rule obeys the Taylor principle, so that the real interest rate is increased when inflation rises above the target inflation rate. We estimate Markov switching models for both inflation and real-time forward looking Taylor rules. Inflation appears to have a unit root for most of the 1967 – 1981 period, but is stationary before 1967 and after 1981. We find that the Fed’s response to inflation is also regime dependent, with the pre and post-Volcker samples both containing monetary regimes where the Fed did and did not follow the Taylor principle. (June 2009)

 

Time Series Tests of Constant Steady-State Growth

 

(with Ruxandra Prodan)

 

We propose a new methodology to study the stability of steady-state growth. Long-run GDP per capita can be characterized by: (1) the linear trend hypothesis, where there are no long-run changes in GDP levels or growth rates, (2) the level shift hypothesis, where there are long-run level shifts, but not changes in growth rates, and (3) the growth shift hypothesis, where there are long-run changes in both GDP levels and growth rates. We formally test these hypotheses using time series techniques with over 135 years of data. The results are not favorable to the hypothesis of constant steady-state growth. While we find evidence supporting the linear trend hypothesis for the United States and Canada and the level shift hypothesis for three additional OECD countries, the growth shift hypothesis is supported for seven OECD and four Asian countries. (August 2009)

 

Testing for Group-Wise Convergence with an Application to Euro Area Inflation

 

(with Claude Lopez)

 

We propose a new procedure to increase the power of panel unit root tests when used to study convergence by testing for stationarity between a group of series and their cross-sectional means. When testing for stationarity of the differential between a group of series and their cross-sectional means, although each differential has non-zero mean, the group of differentials has a cross-sectional average of zero for each time period by construction. We incorporate this constraint for estimation and generating finite sample critical values. Applying this new procedure to Euro Area inflation, we find strong evidence of convergence among the inflation rates soon after the implementation of the Maastricht treaty and a dramatic decrease in the persistence of the differential after the occurrence of the single currency. (June 2009)

 

Median-Unbiased Estimation in DF-GLS Regressions and the PPP Puzzle

 

(with Claude Lopez and Christian Murray)

 

Using median-unbiased estimation based on Augmented-Dickey-Fuller (ADF) regressions, recent research has questioned the validity of Rogoff’s “remarkable consensus” of 3-5 year half-lives of deviations from PPP. The confidence intervals of these half-life estimates, however, are extremely wide, with lower bounds of about one year and upper bounds of infinity. We extend median-unbiased estimation to the DF-GLS regression of Elliott, Rothenberg, and Stock (1996). We find that combining median-unbiased estimation with this regression has the potential to tighten confidence intervals for the half-lives. Using long horizon real exchange rate data, we find that the typical lower bound of the confidence intervals for median-unbiased half-lives is just under 3 years. Thus, while previous confidence intervals for median-unbiased half-lives are consistent with virtually anything, our tighter confidence intervals are inconsistent with economic models with nominal rigidities as candidates for explaining the observed behavior of real exchange rates and move us away from solving the PPP puzzle. (February 2009)

 

 

 

 

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