Taylor Rule Deviations and Financial Imbalances

By Kahn, George A. | Economic Review (Kansas City, MO), Spring 2010 | Go to article overview

Taylor Rule Deviations and Financial Imbalances


Kahn, George A., Economic Review (Kansas City, MO)


Over the last quarter century, the U.S. economy has faced a number of financial shocks originating in a variety of sectors and locations around the globe. These shocks include the high-tech stock market crash, the Asian financial crisis, the Russian debt default, and most recently, the U.S. housing price collapse and subsequent global financial crisis. While the U.S. economy weathered most of these shocks with little or no impact on economic activity, it fell into its worst recession since the Great Depression as a result of the 2008 global financial crisis.

The causes of these crises are as diverse as the nature of the crises themselves. To some extent, however, a buildup of financial imbalances preceded each crisis. In some cases, asset prices rose to unsustainable levels inconsistent with market fundamentals. In other cases, a buildup of foreign debt precipitated a currency crisis. A key question for policymakers is whether policy actions taken in the period leading up to the crisis leaned against, or contributed to, the building imbalances. In particular, did monetary policies targeting stable inflation and sustainable long-term economic growth inadvertently exacerbate these imbalances by keeping policy-controlled interest rates too low for too long?

Answering this question requires first defining what "too low for too long" means. This article uses deviations from systematic or rule-like behavior in the setting of policy rates as an indicator of whether policy was too easy or, for that matter, too tight. In particular, deviations are measured as departures from various versions of the Taylor rule, which prescribes a systematic setting for the policy rate based on inflation relative to an inflation target and real output relative to potential output. Such deviations--especially if they are small and temporary--may represent an appropriate and desirable response to unusual economic or financial conditions. Larger and more persistent deviations, however, may contribute to a buildup of financial imbalances.

A second issue that must be addressed to determine whether monetary policy contributed to financial imbalances is to define what is meant by an imbalance. In this article, an imbalance is defined as a persistent deviation in an asset price or other financial variable from its long-run historical trend. A variety of empirical measures of imbalances are identified in four broad areas--housing markets, stock prices, leverage, and commodity prices. While each measure is an imprecise indicator of a particular imbalance, collectively they may provide insight into the relationship of Taylor rule deviations to building pressures in key sectors of the economy.

The article concludes that, while there does appear to be statistically significant relationships between Taylor rule deviations and a number of financial indicators, their economic significance is mixed. The strongest and most robust relationship is between house price indicators and Taylor rule deviations. In other cases, the relationship is economically weak and sometimes goes in the wrong direction in the sense that interest rates below the prescription of the Taylor rule are associated with smaller rather than larger imbalances. The fragility of the results likely stems from the inherent difficulty of identifying financial imbalances, combined with the irregular emergence of imbalances in different sectors at different times.

The first section of the article describes how deviations from systematic policy are measured and identifies episodes over the last 25 years where these deviations have occurred. The second section explains how these deviations may have contributed to financial imbalances. The third section provides evidence on the relationship between deviations in policy from rule-like behavior and the buildup of financial imbalances.

I. TAYLOR RULE DEVIATIONS

The Taylor rule has become a key guidepost for monetary policy at the Federal Reserve and other central banks (Asso, Kahn, and Leeson). …

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