The taylor curve revisited: filter choice and the evaluation of U.S. monetary policy

This paper employs a standard new Keynesian model to compute the inflation/output volatility frontier, i.e. the Taylor curve. We find that under indeterminacy the tighter is the monetary policy, the higher is the inflation/output gap volatility. This is due to impact of systematic monetary policy on inflation and output persistence in the model. In fact, under indeterminacy a more aggressive monetary policy causes an increase in inflation persistence, and augments its volatility .T he effects on output tend to be of opposite sign. When moving to ’active’ monetary policies the degrees of inflation and output persistence in the model drop remarkably. This finding is robust to different parameterizations of the DSGE new-Keynesian monetary model employed. This result i) offers support to the move from ’passive’ to ’active’ monetary policy as one of the possible rationales for the Great Moderation, ii) underlines the need of a deeper understanding of the link between systematic monetary policy and macroeconomic persistence, and iii) warns against subsamples pooling when performing macroeconometric analysis.

Evaluating inflation-targeting monetary policy is more complicated than checking whether inflation has been on target, because inflation control is imperfect and flexible inflation targeting means that deviations from target may be deliberate in order to stabilize the real economy. A modified Taylor curve, the forecast Taylor curve, showing the tradeoff between the variability of the inflation-gap and output-gap forecasts can be used to evaluate policy ex ante, that is, taking into account the information available at the time of the policy decisions, and even evaluate policy in real time. In particular, by plotting mean squared gaps of inflation and output-gap forecasts for alternative policy-rate paths, it may be examined whether policy has achieved an efficient stabilization of both inflation and the real economy and what relative weight on the stability of inflation and the real economy has effectively been applied. Ex ante evaluation may be more relevant than evaluation ex post, after the fact. Publication of the interest-rate path also allows the evaluation of its credibility and the effectiveness of the implementation of monetary policy.

Evaluating inflation-targeting monetary policy is more complicated than checking whether inflation has been on target, because inflation control is imperfect and flexible inflation targeting means that deviations from target may be deliberate in order to stabilize the real economy. A modified Taylor curve, the forecast Taylor curve, showing the tradeoff between the variability of the inflation-gap and output-gap forecasts can be used to evaluate policy ex ante, that is, taking into account the information available at the time of the policy decisions, and even evaluate policy in real time. In particular, by plotting mean squared gaps of inflation and output-gap forecasts for alternative policy-rate paths, it may be examined whether policy has achieved an efficient stabilization of both inflation and the real economy and what relative weight on the stability of inflation and the real economy has effectively been applied. Ex ante evaluation may be more relevant than evaluation ex post, after the fact. Publication of the interest-rate path also allows the evaluation of its credibility and the effectiveness of the implementation of monetary policy.

An evaluation of ECB policy in the Euro's big four

Taylor (1979) shows that there is a permanent trade‐off between the volatilities of the output gap and inflation. Although a number of papers argue that the so‐called Taylor curve is a policy menu, we use it as an efficiency locus to gauge the appropriateness of monetary policy. We examine the efficiency of U.S. monetary policy from 1875 onward by measuring the orthogonal distance between the observed volatilities of the output gap and inflation from the Taylor curve. We also identify time periods in which the variability of the U.S. economy changed by observing shifts in this efficiency frontier.

First, evidence shows that loose (tight or weaker) labour market conditions shocks result in an increase (decline) in the output-gap and inflation volatilities. Furthermore, tight labour market conditions shocks result in a pronounced decline in inflation when inflation is above the six per cent inflation threshold. Consequently, the repo rate is tightened (loosened) due to loose (tight) labour market conditions shocks as inflation rises (declines) and the Taylor curve increases (declines). Nonetheless, tight labour market conditions shocks exert a severe negative impact on the output-gap volatility compared to inflation volatility. In addition, when inflation exceeds the 6 per cent threshold, tight labour market conditions shocks assist in lowering inflation and shifting the Taylor curve inwards. As a result, the decline in the output-gap volatility accentuates the decline in the repo rate than the inflation volatility. The decline in the output-gap volatility following tight labour market conditions shocks induces highly accommodative monetary policy. This suggests that tight labour market conditions shocks are transmitted much through the output-gap channel than the inflation channel. Thus, there are price stability benefits that accrue from changes in the labour market conditions and these spill-over into the monetary policy settings.

Cet article vise à déterminer si le ciblage d’inflation implique en pratique un plus fort degré de conservatisme que les autres régimes de politique monétaire. Nous utilisons un indicateur original de conservatisme fondé sur la courbe de Taylor, et recourons à la méthode d’appariement par score de propension. Les résultats indiquent que les cibleurs d’inflation on, en effet, une préférence relative pour la stabilisation de l’inflation significativement plus grande que les non-cibleurs. Ce résultat conduit à s’interroger sur l’opportunité de cette stratégie, alors que la crise financière a montré que la stabilité des prix n’est pas suffisante pour garantir la stabilité macroéconomique et financière.

This article studies the stabilization effect of monetary policy reacting to asset price, accounting for the expectations formation effect of policy regime shift, in a DSGE model calibrated to the US economy. In contrast to the linear policy rule that generates negligible stabilization effect from responding to asset prices, the regime switching policy rule can significantly stabilize inflation-output volatilities. We then identify the range of parameter values that can generate stabilization effect for inflation and find that reacting to asset prices too aggressively can be inflation de-stabilizing. Given certain combinations of parameter values, the trade-off between the expected volatility of inflation and that of output, as demonstrated by the Taylor curve, substantially diminishes, thus considering non-linear policy rule expands the set of monetary policy choices available for monetary authority. Finally, there exists an optimal responsiveness to asset prices.

We use the Taylor curve to gauge deviations of monetary policy from an efficiency locus for the United Kingdom (UK) and the four largest economies of the Eurozone (Germany, France, Italy, Spain) for the period 2000–2018. For this purpose, we use shadow interest rates, which is a common metric for both conventional and unconventional monetary policies, and the newly proposed Hamilton-filter to measure output gap, which improves upon the drawbacks of the traditionally used Hodrick–Prescott filter. Our findings suggest that deviations in the UK mostly occurred amid the global financial crisis and the post-Brexit period, whereas Eurozone members experienced more volatile deviations around 2001, during the global financial crisis and the Eurozone sovereign debt crisis.

PurposeThe objective of this study is to assess the impact of financial development (FD) on monetary policy efficiency (MPE) in developed G7 countries in the period 1980–2017, based on data availability.Design/methodology/approachThis study followed a two-step process as follows: (1) using the Monte Carlo simulation based on Taylor curve theory to build the MPE measure and (2) evaluating the effect of FD on MPE by feasible generalized least squares (FGLS) estimation.FindingsThe results of this study show that (1) MPE varies over time. Monetary policy appears ineffective during the crisis period and is subject to many impacts of domestic and external shocks. On the contrary, the ability to influence the economy to achieve the central bank's goal tends to increase in the recovery stages, and this is in line with the actual. (2) FD has a negative impact on MPE. Interestingly, when considering the role of component FD indicators, the development of financial markets (FMs) has a negative impact on MPE while the development of financial institutions (FIs) has a positive impact. In particular, the impact of FI on MPE is mainly attributed to the impact of the depth of FI. Meanwhile, the impact of FM on MPE is mainly due to the impact of the efficiency in the FM.Originality/valueTo the author’s knowledge, this is the first study that evaluates the impact of FD on MPE in the context of measuring MPE by using the Taylor curve theory. Results from this study suggest a scientific and practical MPE measure and provide significant policy implications. This paper also offers suggestions for future research.

This paper empirically investigates the Taylor curve volatility tradeoff in light of the stochastic behavior of the conditional variances of output and inflation. Stressing structural instability between periods before and after the 1979-1982 monetary policy regime change, I implement a bivariate generalized autoregressive conditional heteroskedasticity model to capture the output-inflation variability tradeoff and to explore the plausible impact of a change in the federal funds rate on the two conditional volatilities. I further evaluate the impacts of anticipated and unanticipated policy actions measured by two alternative policy reaction functions---one from a vector-autoregression-based reduced-form equation and another based on the Taylor rule. In addition to showing a volatility tradeoff relationship, the empirical model reveals different magnitudes of policy effects on output and inflation volatility across the two sample periods.

This paper empirically investigates the Taylor curve volatility tradeoff in light of the stochastic behavior of the conditional variances of output and inflation. Stressing structural instability between periods before and after the 1979‐1982 monetary policy regime change, I implement a bivariate generalized autoregressive conditional heteroskedasticity model to capture the output‐inflation variability tradeoff and to explore the plausible impact of a change in the federal funds rate on the two conditional volatilities. I further evaluate the impacts of anticipated and unanticipated policy actions measured by two alternative policy reaction functions—one from a vector‐autoregression‐based reduced‐form equation and another based on the Taylor rule. In addition to showing a volatility tradeoff relationship, the empirical model reveals different magnitudes of policy effects on output and inflation volatility across the two sample periods.

An empirical investigation of the Taylor curve

Monetary Policy Efficiency and the Taylor Curve: Evidence from Hungary

A growing number of countries have anchored their monetary policy to an explicit numerical rate or range of inflation since such an inflation targeting framework was first adopted by New Zealand in 1989. This paper empirically investigates issues associated with inflation targeting using a dataset of 66 countries for the 1980-2000 period. The paper focuses on two issues. First, which factors are systematically associated with a country's decision to adopt inflation targeting as its monetary framework? Second, does inflation targeting improve the performance of inflation and output? Does the trade-off between inflation and output variability change under such a framework? The empirical results are informative and encouraging. A number of economic conditions, structure, and institution variables are significantly associated with the choice of inflation targeting. Both descriptive statistics and regression results suggest that inflation targeting does play a beneficial role in improving the performance of inflation and output. This paper explores an evident and positive relationship between inflation and output variability, which is different from the view based on the Taylor Curve. But the author finds limited support for the proposition that the adoption of inflation targeting improves the trade-off between inflation and output variability.