Working
Papers

Policy Rules and Economic Performance

(with
Alex Nikolsko-Rzhevskyy and Ruxandra Prodan)

Monetary policy evaluation
has evolved over time from fixed rules versus discretion to policy rules versus
constrained discretion. We propose a metric to evaluate monetary policy rules
by calculating quadratic loss ratios, the (inflation plus unemployment) loss in
high deviations periods divided by the loss in low deviations periods, with
policy rules with higher loss ratios preferred to rules with lower loss ratios.
The central results of the paper are (1) economic performance is better in low deviations
periods than in high deviations periods for the vast majority of rules, (2)
rules with larger coefficients on the inflation gap than on the output gap are
preferred to rules with larger coefficients on the output gap than on the
inflation gap, (3) rules with large coefficients on both gaps are preferred to
rules with small coefficients on both gaps, and (4) rules with larger
coefficients on the inflation gap than on the output gap and large coefficients
on both gaps are strongly preferred to the opposite. This result is robust to
policy lags between one and two years, different weights on inflation loss than
on unemployment loss, various definitions of high and low deviations periods,
time varying equilibrium real interest rates, and replacing the output gap with
an unemployment gap. We conclude that the Fed should “constrain” constrained
direction by following a rule with large coefficients on both gaps that
responds more strongly to inflation gaps than to output gaps. (November 2016)

(with Alex Nikolsko-Rzhevskyy and Ruxandra Prodan)

Suppose that the Fed were to adopt a policy rule. Which rule should it adopt? We propose three criteria. First, the rule should be consistent with good economic performance over a long historical period. Second, the rule should be consistent with recent Fed policy following the Great Recession. Third, the rule should be consistent with projected Fed policy. The first criterion is normative, while the second and third criteria are pragmatic. We consider three rules that have been the focus of extensive policy discussion. The Taylor (1993) and Yellen (2015) rules are “balanced” in the sense that the coefficients on the inflation and output gaps are equal, while the Yellen (2012) rule is an example of an “output gap tilting” rule because the coefficient on the output gap is larger than the coefficient on the inflation gap. We also consider “inflation gap tilting” rules where the coefficient on the inflation gap is larger than the coefficient on the output gap. An inflation gap tilting version of the Yellen (2015) rule with a time-varying equilibrium real interest rate provides the most consistency with the three criteria. (November 2016)

(with Alex
Nikolsko-Rzhevskyy and Ruxandra Prodan)

We use tests for structural change to identify periods of low, positive, and negative Taylor rule deviations, the difference between the federal funds rate and the rate prescribed by the original Taylor rule. The tests define four monetary policy eras: a negative deviations era during the Great Inflation from 1965 to 1979, a positive deviations era during the Volcker disinflation from 1979 to 1987, a low deviations era during the Great Moderation from 1987 to 2000, and another negative deviations era from 2001 to 2014. We then estimate Taylor rules for the different eras. The most important violations of the Taylor principles, the four elements that comprise the Taylor rule, are that the coefficient on inflation was too low during the Great Inflation and that the coefficient on the output gap was too low during the Volcker disinflation. We then analyze deviations from several alterations of the original Taylor rule, which identify a negative deviations era from 2000 to 2007 and a low deviations era from 2007 to 2014. Between 2000 and 2007, Fed policy cannot be explained by any variant of the Taylor rule while, between 2007 and 2014, Fed policy is consistent with a rule where the federal funds rate does not respond at all to inflation and either responds very strongly to the output gap or incorporates a time-varying equilibrium real interest rate. (May 2015)

(Taylor) Rules versus
Discretion in U.S. Monetary Policy

(with Alex
Nikolsko-Rzhevskyy and Ruxandra Prodan)

The
Taylor rule has been the dominant metric for monetary policy evaluation over
the past 20 years, and it has become common practice to identify periods where
policy either adheres closely to or deviates from the Taylor rule benchmark.
The purpose of this paper is to identify (Taylor) rules-based and discretionary
eras solely from the data so that knowledge of subsequent economic outcomes
cannot influence the choice of the dates. We define Taylor rules-based and
discretionary eras by smaller and larger Taylor rule deviations, the absolute
value of the difference between the actual federal funds rate and the federal
funds rate prescribed by the original Taylor rule, and use tests for multiple
structural changes and Markov switching models to identify the eras. Monetary
policy in the U.S. is characterized by a Taylor rules-based (low deviations)
era until 1974, a discretionary (high deviations) era from 1974 to about 1985,
a rules-based era from about 1985 to 2000, and a discretionary era from 2001 to
2013. The Taylor rule deviations are about three times as large in the
discretionary eras than in the rules-based eras. The discretionary and
rules-based eras closely correspond to periods where the Taylor rule deviations
are above and below two percent. We calculate various loss functions and find
that economic performance is uniformly better during (Taylor) rules-based eras
than during discretionary eras.
(January 2015)

Real-Time
Historical Analysis of Monetary Policy Rules

(with Alex
Nikolsko-Rzhevskyy)

The size of the output gap coefficient
is the key determinant of whether quantitative easing since 2009 and continued
near-zero interest rates can by justified by a Taylor rule. Fed Chair Ben
Bernanke and Vice-Chair Janet Yellen have argued that John Taylor proposed a
monetary policy rule with a larger output gap coefficient in his 1999 paper
than in his 1993 paper, and have used this argument to justify negative
prescribed interest rates in 2009-2010 and near-zero interest rates through
2015. While Taylor neither proposed nor advocated a different rule in 1999 than
in 1993, he did not draw a distinction between the implications of the two
rules. In accord with common practice at the time, Taylor used revised data. We
show that, using real-time data available to policymakers (although not to
Taylor when he wrote the paper), there is a sharp difference in the
implications of rules with a smaller and a larger output gap coefficient. If John Taylor had been able to use real-time data in
his 1999 paper, the importance of the distinction between Taylor’s original
rule with a smaller output gap coefficient and other rules with a larger
coefficient would have been evident much earlier. (May 2013)

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