Estimating Interest Rate Setting Behavior in Brazil: A LSTR Model Approach

Yosra Baaziz

doi:10.3390/economies3020055

Abstract

Given limited research on monetary policy rules in emerging markets, this paper challenges the applicability of a nonlinear Taylor rule in characterizing the monetary policy behavior of the Brazilian Central Bank. It also investigates whether and how the process of setting interest rates has been developed in response to contingencies and special events. We extend the linear Taylor rule to a regime-switching framework, where the transition from one regime to another occurs in a smooth way, using a Logistic Smooth Transition Regression (LSTR) approach. In this sense, we empirically analyze the movement of the nominal short term interest rate of the Brazilian Central Bank using quarterly data, covering the period 1994.Q4–2012.Q2. We find that the nonlinear Taylor rule provides a better description of the Brazilian interest rate setting and is consistent with historical macroeconomic events. In particular, our results show that adopting a nonlinear specification, instead of the linear, leads to a costs reduction in terms of ﬁt: 190 basis points in 1995 and 140 basis points in the mid-2002 presidential election campaign in Brazil. Moreover, the Brazilian monetary policy exhibits nonlinear patterns that better captures special events and may contain relevant information rendering it applicable to unusual conditions, i.e., a financial crisis, which require disconnection from the automatic pilot rule and use of judgement to make decision.

Highlights

Taylor (1993) [1], in his seminal contribution, proposed a simple monetary policy rule, linking mechanically policy interest rate to deviating of inflation from its target and output from its potential.The Taylor rule has been a popular gauge for assessing monetary policy performance both advanced economies and emerging economies
Π represents the target value of inflation. πt is the inflation rate at time t calculated from the consumer price index (CPI), reflecting cost of acquiring a fixed basket of goods and services by an average consumer. refers to the output gap, defined as the difference between actual output and potential output, which is measured using the Hodrick-Prescott (1997)’s [43] filter. bπ indicates the sensitivity of the interest rate policy to deviations of inflation from its target. by represents the coefficient of the reaction of the central bank to the output gap
Using monthly data from 1994 to 2012 to analyze the movement of the nominal short term interest rate for Brazilian Central Bank, we confirm the occurrence of nonlinearity in the Taylor rule

Summary

Introduction

Taylor (1993) [1], in his seminal contribution, proposed a simple monetary policy rule, linking mechanically policy interest rate to deviating of inflation from its target and output from its potential. The Taylor rule has been a popular gauge for assessing monetary policy performance both advanced economies and emerging economies. It is important to bear in mind that the Taylor rule has its limitations and pitfalls. In this respect, variants of Taylor-type regressions have been applied extensively in order to understand and model the behavior of monetary policy for many countries. Some researchers include a lagged interest rate term to model the monetary policy inertia or interest rate smoothing behavior (Clarida et al 1998 [2]).

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