Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

A Taylor Rule and the Greenspan Era

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

A Taylor Rule and the Greenspan Era

Article excerpt

(ProQuest: ... denotes formulae omitted.)

There is considerable interest in determining whether monetary policy actions taken by the Federal Reserve under Chairman Alan Greenspan can be summarized by a Taylor rule. The original Taylor rule relates the federal funds rate target to two economic variables: lagged inflation and the output gap, with the actual federal funds rate completely adjusting to the target in each period (Taylor 1993).1 The later assumption of complete adjustment has often been interpreted as indicating the policy rule is "non-inertial," or the Federal Reserve does not smooth interest rates. Inflation in the original Taylor rule is measured by the behavior of the GDP deflator and the output gap is the deviation of the log of real output from a linear trend. Taylor (1993) shows that from 1987 to 1992 policy actions did not differ significantly from prescriptions of this simple rule. Hence, according to the original Taylor rule, the Federal Reserve, at least during the early part of the Greenspan era, was backward looking, focused on headline inflation, and followed a non-inertial policy rule.

Recent research, however, suggests a different picture of the Federal Reserve under Chairman Greenspan. English, Nelson, and Sack (2002) present evidence that indicates policy actions during the Greenspan period are better explained by an "inertial" Taylor rule reflecting the presence of interest rate smoothing.2 Blinder and Reis (2005) state that the Greenspan Fed focused on a "core" measure of inflation in adjusting its federal funds rate target. Clarida, Galí, and Gertler (2000), among others, have shown that a forward-looking Taylor rule that relates the current funds rate target to "expected" inflation and output developments appears to fit the data quite well over the period spanning the tenures of Chairmen Paul Volcker and Alan Greenspan. Orphanides (2001) argues that policy evaluations using policy rules estimated with the final revised data may be misleading.

This article estimates a Taylor rule that address three key features of the Greenspan period highlighted in recent research: the Federal Reserve under Greenspan was forward looking, focused on core inflation, and smoothed interest rates. Furthermore, this article uses the real-time data for economic variables and investigates whether results based on the final, revised data change when the real-time data are used. We also examine whether the use of real-time data leads to a better explanation of policy actions during the Greenspan period.

ATaylor rule incorporating the above-noted three features is shown below in equation (1.3).

... (1.1)

... (1.2)

... (1.3)

where FRt is the actual federal funds rate, ... is the federal funds rate target, ... is the j -period ahead forecast of core inflation made at time t , ln y is the log of actual output, ln y* is the log of potential output, and vt is the disturbance term. Thus, the term (...) is the k-period ahead forecast of the output gap. Equation (1.1) relates the federal funds rate target to expected values of two economic fundamentals: core inflation and the output gap. The funds rate target is hereafter called the policy rate. The coefficients απ and αy measure the long-term responses of the funds rate target to the expected inflation and the output gap. They are assumed to be positively signed, indicating that the Federal Reserve raises its funds rate target if inflation rises and/or the output gap is positive. Equation (1.2) is the standard partial adjustment equation, expressing the current funds rate as a weighted average of the current funds rate target ... and last quarter's actual value FRt-1. If the actual funds rate adjusts to its target within each period, then ρ equals zero, which suggests that the Federal Reserve does not smooth interest rates. Equation (1.2) also includes a disturbance term, indicating that in the short run, the actual funds rate may deviate from the value implied by economic determinants specified in the policy rule. …

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