Estimates of US monetary policy rules with allowance for changes in the output gap

Abstract

This article estimates a reduced form Taylor rule for the Pre-Volcker and Volcker–Greenspan periods. A novelty is that it follows a suggestion of Walsh and includes changes in the output gap as an explanatory variable. Either this variable or an interaction term between inflation and changes in the output gap are highly significant in both periods. The response to inflation and the interaction term are higher in the Volcker–Greenspan period of office.

Notes

 The need to reflect asymmetric preferences in models of optimal monetary policy is underlined by the explicit inflation target objectives of the European Central Bank. Its target of a year on year increase in the consumer price index of 2% or less in essence amounts to an asymmetric target.

 Such an approach is motivated by the views expressed by leading Central Bankers. For instance in testimony before the Senate committee that was meeting to consider his nomination to the Federal Reserve Board, former Vice Chairman Blinder summarized his views on this issue as follows:

(If monetary policy is used to cut our losses on the inflation front when luck runs against us, and pocket the gains when good fortune runs our way, we can continue to chip way at the already-low inflation rate: Blinder, 1994 p. 4).

 Walsh also notes that in remarks at the Wharton Public Policy Forum in 22 April 1999, Fed Governor Edward M. Gramlich also describes monetary policy in terms of a focus on demand growth relative to growth in potential output: ‘Solving a standard model of the macroeconomy, such a policy would effectively convert monetary policy into what might be called “speed limit” form, where policy tries to ensure that aggregate demand grows at roughly the expected rate of increase of aggregate supply, which increase can be more easily predicted’. ‘ … the monetary authority is happy with the cocktail party temperature at present but moves against anything that increases its warmth. Should demand growth threaten to outrun supply growth (the party to warm up), the seeds of accelerating inflation may be planted and monetary policy should curb the growth demand by raising interest rates.’

 One also notes that Giannoni and Woodford (2002) showed that a Taylor rule with changes in the output gap as an argument will implement the optimal response to real shocks in a wide class of models.

 The data is quarterly from 1960: [to 2003:]. Inflation is measured as the (annualized) rate of change of the GDP deflator (P _t ) between two subsequent quarters:

The output gap, (gap_t), measure we employ is 100 times the difference between the logarithms of real GDP and the estimate for potential real GDP constructed by the Congressional Budget (CBO). The interest rate is the average Federal Fund rate in the first-month of each quarter, expressed at annual rates. All these series were downloaded from the Federal Reserve Bank of St. Louis.

 No attempt was made to derive the Taylor rule as a solution to an explicit optimization procedure. Closed-form solutions for the optimal policy rule are not obtainable for the type of objective function that is, a priori, feasible.