Forward-looking Monetary Policy Rule Research Articles

Is the future really observable? A practical approach to model monetary policy rules

We take a practical approach to model the forward-looking monetary policy rule. Unlike existing studies, we recognize that the forward-looking components—future inflation and output growth—are intrinsically unobserved at the time policy formulation. Using the unobserved components framework, we extract the latent components of the policy rule from the short-term and long-term Greenbook forecasts, both individually and in combination, and jointly estimate the policy parameters. We also consider correlations between different components and combine the forecasts from the survey of professional forecasters and the inflation index bonds market. Evidence suggests that the Federal Reserve follows an inflation-tilted policy rule and the long-term state of economy gets a higher weight than the short term. Also, the policy reaction is more aggressive when interconnections between different components of the policy rule are considered.

Does the Reserve Bank of Australia follow a forward-looking nonlinear monetary policy rule?

ABSTRACTThe conventional monetary policy rule describes a simple linear relationship between the domestic interest rate, inflation rate and output gap. An important extension to this rule is to incorporate the forward-looking behaviour of central banks, where it is assumed that they target an expected level of inflation instead of its current realised value. Using quarterly observations for the period 1993:1-2018:2, this paper investigates whether the conduct of monetary policy in Australia can be described by a forward-looking linear monetary policy rule, or by a nonlinear forward-looking monetary policy rule. In particular, the nonlinear forward-looking monetary policy rule is analysed in a regime-switching framework using a smooth logistic transition regression model. While the results show that the conventional forward-looking linear monetary policy rule describes the application of monetary policy in Australia reasonably well, the interest rate setting behaviour of the RBA is best described by a nonlinear forward-looking monetary policy rule.

Is Chinese Monetary Policy Forward-Looking?

This paper investigates the empirical validity of the claim that China employed a forward-looking monetary policy rule from 2001 to 2016. Survey expectations are used in conjunction with competing money supply and interest rate rules. The paper contributes to the literature by addressing the problems of serial correlation and structural breaks in the underlying policy reaction function. Un-like earlier studies indicating a strong role for expectations in Chinese monetary policy, we find expectations only began to play a significant role after 2008. This finding is robust for expectations series based on surveys of both households and forecasting experts. We also find that the People’s Bank of China promotes economic growth in procyclical fashion, but applies countercyclical policy in managing inflation.

TIME-VARYING COEFFICIENT TAYLOR RULE AND CHINESE MONETARY POLICY: EVIDENCE FROM THE TIME-VARYING COINTEGRATION

(ProQuest: ... denotes formulae omitted.)1.INTRODUCTIONThe Chinese economy, known as the miracle, has maintained steady and fast growth for three decades, and attracts much attention from scholars and practitioners. Unlike Eastern European countries, China undergoing a gradual market-oriented reform in which its economic structure and regime are changing slowly and smoothly. For this reason, it is of great importance to study whether existing economic theory can be applied to China. In macroeconomics, the proposed by Taylor (1993), is an important monetary policy that specifies how the US Federal Reserve should adjust its targeted interest rate to the inflation and output gaps. Studying the validity of the Taylor rule for China is theoretically and practically important.There is a vast literature on the Taylor rule. For example, Taylor (1999) studied the validity of the Taylor rule using historical data covering 1897 to 1914 and 1955 to 1997, finding that the deviation of the actual interest rate from the targeted interest rate could help reflect the effectiveness of monetary policy. Kim and Nelson (2006) proposed a time-varying parameter forward-looking monetary policy rule and provided an efficient estimation using the Kalman filter. Yuksel, Metin-Ozcan, and Hatipoglu (2013) introduced an interest rate pass-through specification of the monetary transmission process in a general Taylor model. Xie and Luo (2002) were the first to check the validity of the Taylor rule for China, finding that it was a good measure for Chinese monetary policy and provided a reference for Chinese monetary policy implementation. However, Bian (2006) showed that the Taylor rule was unstable in China by using the GMM and cointegration test approach. Zheng and Liu (2010) developed a regime-switching Taylor rule with a time-varying inflation target, and showed that the Chinese monetary policy rule could be significantly divided into passive and active regimes.As Osterholm (2005) pointed out, however, previous studies ignored the nonstationarity of the variables in the Taylor rule model, despite the enormous body of literature. On one hand, the variables might not be stationary processes. Given the variable's unit root behavior, the cointegration relationships among them become essential for regression modeling. In the absence of cointegation, the model would be a spurious regression. On the other hand, the traditional fixed coefficient cointegration approach assumes a constant long-run equilibrium relationship among the variables, thus failing to capture the dynamic structure of the equilibrium relationship. China's gradual reform process is leading to a smooth structural change in the relevant economic variable and market, such as stock markets (Huang et al., 2000) and interest rate. For example, China is gradually carrying out interest rate liberalization. First, inter-bank lending and bond markets were deregulated in 1996; then, the ceiling on deposit rates and the floor on lending rates of commercial banks were relaxed; then, the Shanghai Interbank Offered Rate (Shibor) became China's benchmark rate in 2007; and then, the lending interest rate was completely decontrolled in 2013. Accordingly, this paper considers the smooth and gradual structural change occurring in China rather than abrupt structural breaks.This paper develops a time-varying coefficient Taylor rule to study China's monetary policy. Given the nonstationarity of the model's variables, the paper employs the time-varying cointegration approach of Park and Hahn (1999). To the best of our knowledge, this paper is the first to examine the Taylor rule through the time-varying cointegration approach. Kim and Nelson (2006) also considered the time-varying coefficient Taylor rule, but failed to consider the nonstationarity of the variables. By using several unit root tests, we found that the interest rate, the inflation gap and the output gap are indeed nonstationary. …

The New Keynesian Dsge Model and Alternative Monetary Policy Rules in the Czech Republic

The paper deals with a comparison of alternative monetary policy rules also known as Taylor rules. First, a New Keynesian DSGE model is specifi ed. Results of this model are used as a benchmark. These results are obtained using Bayesian techniques. Bayesian techniques are used for both the estimation and the subsequent model comparison. The main experiment introduces three modifi cations to monetary policy rules. One specifies simple, Svensson and forward-looking monetary policy rules. The estimation is performed on Czech data and the period is from 2000Q1 to 2012Q3. Each specifi cation of the New Keynesian model contains the same observed variables, GDP growth and inflation. The estimation of the benchmark model contains an interesting output as a shock decomposition of both the observed variables. The main finding of this paper is that the parameter estimates of all the modifications of monetary policy rules are almost the same and the log data density looks very similar for all the specified models. On the other hand, a completely opposite conclusion may be derived from the results of the Bayesian comparison of the DSGE models. The key output is that a forward-looking monetary policy rule significantly improves the ability of the New Keynesian DSGE model to fit the observed data.

Forward-looking monetary policy rule and economic stability

A forward looking monetary policy rule has been estimated for the time period from 1991 to 2010 for Pakistan, an emerging economy. The estimated model explains a very clear shift in monetary policy objective across the sample period. State Bank of Pakistan, from 2000 onwards, seems to take insufficient measures for curtaining inflationary pressure. We also simulate a new Keynesian model to investigate the impact of such monetary policies. We show that policies in near past had a destabilizing effect on economy. Key words: Monetary policy, forward looking monetary policy rule, generalized method of moments, accommodative monetary policy.

Forward-Looking Monetary Policy Rule and Economic Stability

A forward looking monetary policy rule has been estimated for the time period from 1991 to 2010 for Pakistan, an emerging economy. The estimated model explains a very clear shift in monetary policy objective across the sample period. State Bank of Pakistan, from 2000 onwards, seems to take insufficient measures for curtaining inflationary pressure. We also simulate a new Keynesian model to investigate the impact of such monetary policies. We show that policies in near past had a destabilizing effect on economy.

Inflation targeting makes the difference: Novel evidence on inflation stabilization

Though Svensson (1997, 2003) provides theoretical evidence that the introduction of inflation targeting is consistent with an inflation stabilizing monetary policy, empirical evidence that the introduction of inflation targeting actually changes central bank’s behavior is still missing. This paper aims to close this gap and estimates forward-looking monetary policy rules for 20 inflation targeting countries. To this end, we use a data set which is available to the central bank in real-time, published on a frequently basis, comparable among all countries, and which includes the periods before and after the introduction of inflation targeting. We find that the introduction of inflation targeting significantly shifts the central bank’s reaction function toward inflation stabilizing. We also provide evidence of time-varying effects and find that central banks stabilize inflation once inflation targeting is introduced. We take our results as strong evidence that the introduction of inflation targeting makes the difference for monetary policy strategies.

Monetary policy rules for a developing country: Evidence from Pakistan

This paper estimates forward-looking monetary policy rules to examine the interest rate setting behavior of the State Bank of Pakistan. Considering the external constraints on monetary policy, core inflation and a country-specific measure of the output gap, we demonstrate that the State Bank of Pakistan reacts to changes in inflation, the output gap and the federal funds rate.

Expectations, Bond Yields, and Monetary Policy

Through explicitly incorporating analysts' forecasts as observable factors in a dynamic arbitrage-free model of the yield curve, this research proposes a framework for studying the impact of shifts in market sentiment on interest rates of all maturities. An empirical examination reveals that survey expectations about inflation, output growth, and the anticipated path of monetary policy actions contain important information for explaining movements in bond yields. Estimates from a forward-looking monetary policy rule suggest that the central bank exhibits a preemptive response to inflationary expectations while accommodating output growth and monetary policy expectations. Forecasted GDP growth plays a significant role in explaining time variation in the market prices of risk. The sensitivity of long yields is linked to the persistence of expected inflation under the risk-neutral measure. Models of this type may provide traders and policymakers with a new set of tools for formally assessing the reaction of bond yields to shifts in market expectations.

Forward-Looking Monetary Policy Rules and Option-Implied Interest Rate Expectations

This paper examines the association between option-implied interest rate distributions and macroeconomic expectations in the context of a forward-looking monetary policy rule. We presume that market participants view the policy rule as a guide to the path of future policy rates and price interest rate options in accordance with the policy rule fundamentals. Using data from the UK, we confirm that Libor expectations implied by option prices are consistent with the policy rule variables. The results demonstrate that changes in the distributional form of Libor expectations are strongly associated with changes in the expected inflation and output gaps and financial uncertainty.

Expectations, Bond Yields and Monetary Policy

Through explicitly incorporating analysts' forecasts as observable factors in a dynamic arbitrage-free model of the yield curve, this research proposes a framework for studying the impact of shifts in market sentiment on interest rates of all maturities. An empirical examination reveals that survey expectations about inflation, output growth, and the anticipated path of monetary policy actions contain important information for explaining movements in bond yields. Estimates from a forward-looking monetary policy rule suggest that the central bank exhibits a preemptive response to inflationary expectations while accommodating output growth and monetary policy expectations. Forecasted GDP growth plays a significant role in explaining time variation in the market prices of risk. The sensitivity of long yields is linked to the persistence of expected inflation under the risk-neutral measure. Models of this type may provide traders and policymakers with a new set of tools for formally assessing the reaction of bond yields to shifts in market expectations.

Estimation of a forward-looking monetary policy rule: A time-varying parameter model using ex post data

In this paper, we consider estimation of a time-varying parameter model for a forward-looking monetary policy rule, by employing ex post data. A Heckman-type (1976. The common structure of statistical models of truncation, sample selection, and limited dependent variables and a simple estimator for such models. Annals of Economic and Social Measurement 5, 475–492) two-step procedure is employed in order to deal with endogeneity in the regressors. This allows us to econometrically take into account changing degrees of uncertainty associated with the Fed's forecasts of future inflation and GDP gap when estimating the model. Even though such uncertainty does not enter the model directly, we achieve efficiency in estimation by employing the standardized prediction errors for inflation and GDP gap as bias correction terms in the second-step regression. We note that no other empirical literature on monetary policy deals with this important issue. Our empirical results also reveal new aspects not found in the literature previously. That is, the history of the Fed's conduct of monetary policy since the early 1970s can in general be divided into three subperiods: the 1970s, the 1980s, and the 1990s. The conventional division of the sample into pre-Volcker and Volcker–Greenspan periods could mislead the empirical assessment of monetary policy.

Monetary policy rules: Forward-looking and backward-looking in an overlapping generations model

In the framework of an overlapping generations model, forward-looking monetary policy rules and backward-looking monetary policy rules were investigated. It is shown that the monetary steady state is more likely to be indeterminate under an active forward-looking rule than under the corresponding backward-looking rule. It is also shown that backward-looking rules can render the monetary steady state unstable.

Counter-Cyclical and Counter-Inflation Monetary Policy Rules and Comovement Properties of Money Growth

This paper shows that counter-cyclical and counter-inflation monetary policy rules are crucial for monetary business cycle models to match the observed negative (or weak) correlation of the growth rate of money and output, inflation, and the interest rate at business cycle frequencies, which were reported as puzzling in Cooley and Hansen (1998) under the AR-1 money growth rate rule. The results are robust for both flexible and sticky price models. Regarding the relative performance of the realistic and/or estimated monetary policy rules in matching the comovement properties of money growth, the feedback interest rate setting rule on output and inflation, which is consistent with a simple VAR model, outperforms the policy rule suggested by Taylor (1993), the forward-looking monetary policy rule as in Clarida, Gali, and Gertler (2000), the feedback money growth rate rules on output and inflation, and the feedback money growth rate rules on productivity shocks.

Estimation of a Forward-Looking Monetary Policy Rule: A Time-Varying Parameter Model using Ex-Post Data

In this paper, we consider estimation of a time-varying parameter model for a forward-looking monetary policy rule, by employing ex-post data. A Heckman-type (1976) two-step procedure is employed in order to deal with endogeneity in the regressors. This allows us to econometrically take into account changing degrees of uncertainty associated with the Fed's forecasts of future inflation and GDP gap when estimating the model. Even though such uncertainty does not enter the model directly, we achieve efficiency in estimation by employing the standardized prediction errors for inflation and GDP gap as bias correction terms in the second-step regression. We note that no other empirical literature on monetary policy deals with this important issue. Our empirical results also reveal new aspects not found in the literature previously. That is, the history of the Fed's conduct of monetary policy since the early 1970's can in general be divided into three sub periods: the 1970's, the 1980's, and 1990's. The conventional division of the sample into pre-Volcker and Volcker-Greenspan periods could mislead the empirical assessment of monetary policy.

Assessing Generalized Method-of-Moments Estimates of the Federal Reserve Reaction Function

Estimating a forward-looking monetary policy rule by the generalized method of moments (GMM) has become a popular approach. We reexamine estimates of the Federal Reserve reaction function using several GMM estimators and a maximum likelihood (ML) estimator. First, we show that over the baseline period 1979–2000, these alternative approaches yield substantially different parameter estimates. Using Monte Carlo simulations, we show that the finite-sample GMM bias can account for only a small part of the discrepancy between estimates. We find that this discrepancy is more plausibly rationalized by the serial correlation of the policy shock, causing misspecification of GMM estimators through lack of instrument exogeneity. This correlation pattern is related to a shift in the reaction function parameters around 1987. Reestimating the reaction function over the 1987–2000 period produces GMM estimates that are very close to the ML estimate.

Real Exchange Rate Persistence and Systematic Monetary Policy Behaviour

This paper estimates forward-looking monetary policy rules for Germany over the 1979-98 period and for the United Kingdom for the periods 1979-90 and 1992-98. The estimation results indicate that there were substantial differences between systematic monetary policy in Germany and in the United Kingdom, as well as shifts in systematic monetary policy in the United Kingdom, over this period. The paper analyses the implications of these estimated policy rules for real exchange rate behaviour in an open economy dynamic stochastic general equilibrium model. The analysis shows that real exchange rate persistence could be attributed to the persistence of real shocks and interest rate smoothing behaviour of central banks. However, the observed cross-country asymmetry in systematic monetary policy behaviour elevates real exchange rate persistence to realistic levels, whereas changes in asymmetric policy behaviour alter the character of real exchange rate persistence.

Assessing GMM Estimates of the Federal Reserve Reaction Function

Estimating a forward-looking monetary policy rule by the Generalized Method of Moments (GMM) has become a popular approach since the influential paper by Clarida, Gali, and Gertler (1998). However, an abundant econometric literature underlines to the unappealing small-samples properties of GMM estimators. Focusing on the Federal Reserve reaction function, we assess GMM estimates in the context of monetary policy rules. First, we show that three usual alternative GMM estimators yield substantially different results. Then, we compare the GMM estimates with two Maximum-Likelihood (ML) estimates, obtained using a small model of the economy. We use Monte-Carlo simulations to investigate the empirical results. We find that the GMM are biased in small sample, inducing an overestimate of the inflation parameter. The two-step GMM estimates are found to be rather close to the ML estimates. By contrast, iterative and continuous-updating GMM procedures produce more biased and more dispersed estimators.

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