Academic journal article Contemporary Economic Policy

Targets in the Taylor Rule: Inflation, Speed Limit, or Price Level?

Academic journal article Contemporary Economic Policy

Targets in the Taylor Rule: Inflation, Speed Limit, or Price Level?

Article excerpt

I. INTRODUCTION

A remarkably large empirical and theoretical literature dedicated to the study of monetary policy in the United States has evolved over the last two decades. Taylor (1993) was among the first to suggest that the Federal Reserve may be following a simple instrument rule by setting the nominal interest rate in response to inflation and the output gap. Clarida, Gall, and Gertler (1999, 2000) comprehensively show that the eponymous Taylor rule indeed well characterizes the conduct of monetary policy in the United States, once the adjustment for interest-rate persistence has been made. Svensson (2002, 2003), however, has long criticized the use of such rules in theoretical work, in part because no central bank has formally committed to such a rule. He has also argued that these instrument rules provide a simplistic view of monetary policy conduct, ignoring important problems that monetary policy-makers have to confront and that can be better addressed in the context of targeting rules whereby the central bank minimizes a social welfare loss function.

One such problem is the time inconsistency of monetary policy, originally pioneered by Kydland and Prescott (1977). Insofar as the behavior of agents is modeled as forward-looking, optimal policy will manipulate these expectations so as to achieve maximum social welfare. At a given point in time, however, policy-makers will have an incentive to renege on their previous promises, which is why this policy is time inconsistent. A large body of literature has evolved that studies a central bank's inability to optimize over the forward-looking variables because of the lack of a commitment device. Within this literature are proposals for alternative discretionary targeting rules that a central bank can employ to bring social welfare outcomes closer to the level that would be attained, were such a device available. Under these rules, the central bank minimizes a social welfare loss function that differs from that of society. Svensson (2002, 2003) has called rules that derive explicitly from this optimization problem "targeting" (and the terms in the social welfare loss "targets") and rules that define the evolution of the nominal interest rate as a function of other macroeconomic variables "instrument." We review the key contributions to the study of targeting rules that are relevant for this paper, which focuses on the theoretical properties of related instrument rules and presents their estimates using the Greenbook data.

Walsh (2003) argues that the communication of the Federal Reserve officials is consistent with a so-called speed-limit target (SLT) that takes the form of an output gap growth term in place of an output gap level. He then shows that having this target in the welfare loss function delivers outcomes that are closer to the optimal preconunitment ideal than under alternative targets. Gorodnichenlco and Shapiro (2007) link this strand of theoretical literature that takes place in the targeting context with an empirical one that estimates instrument rules from the data. They do so by introducing price-level targeting (PLT) into the interest-rate reaction function, rather than the social welfare loss objective. They present evidence from the ex post data that the Fed follows a hybrid rule that is closer to strict PLT rather than the standard Taylor rule, which they associate with inflation targeting (IT).

This paper conflates and builds on these two approaches. We argue that the evidence in favor of SLT is much stronger than PLT by estimating an interest-rate reaction function for the Federal Reserve. Furthermore, we show that the modified version of the instrument SLT rule has stabilizing properties that are very similar to PLT and, in some ways, superior to it. One important distinction of this paper from the work conducted by Gorodnichenko and Shapiro (2007) is our use of the real-time data from the Federal Reserve's Greenbook. …

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