An augmented Taylor rule for the Federal Reserve's response to asset prices

Abstract

This paper investigates whether and how the US Federal Reserve has reacted to asset price developments over the period 1979-2011. We examine both the opportunities and limitations of incorporating two asset prices, equity and real estate, into a standard forward-looking and inertial interest rate rule, based on ex-post realised monthly data and taking into account the inherent endogeneity. While the role of house prices is found to be ambiguous due to weak identification, stock prices do represent an important aspect of the Federal Reserve's monetary policy design. Our findings suggest that monetary policymakers did not target stock prices systematically, but rather reacted on few occasions during the full sample period, when misalignments in stock prices were relatively large.

Should Monetary Policy in South Africa Lean against the Wind by Targeting the Financial Cycle?

“…The a priori expectation is a negative and significant coefficient with a value close 0.5 in the CFCI parameter, in accordance with the literature (Hafner and Lauwers 2017;Nair and Anand 2020). The value of 0.5 implies that the SARB can lean against the wind by targeting the aggregate FC as a fully flagged objective, while lower values indicate targeting the FC only as a genuine augmentation.…”

“…In accordance with Hafner and Lauwers (2017), the wide applicability of the original Taylor rule model came from its simplicity, intuitiveness, and its realism. However, this original version became slightly outdated as it was based on the assumptions that the central bank is backward-looking and trails on the non-inertial policy rule.…”

“…Hence, it acts as a true reflection of the dynamics of the financial system. While the normative issues of the appropriateness of MP responses to financial system indicators, such as asset prices, credit, and equity, have been of interest in the literature (Bernanke et al 1999;Hafner and Lauwers 2017), the major innovation of this article is the incorporation of a composite financial cycle index (CFCI) measured through the amalgamation of eleven monthly financial time series indicators into the conventional Taylor rule, thus forming what is here referred as the finance-augmented Taylor rule.…”

“…where r t is the short-term nominal interest rate assumed to adjust to the target rate each period; r * denotes the equilibrium real interest rate; π * is the central banks' inflation target; π t is the present inflation rate given as the percentage change in the price level; y t denotes the output gap, which is the difference between actual output and potential output; ∅ 1 and ∅ 2 denote the sensitivity of the interest rate towards deviations of inflation and output from their target and potential levels, respectively (Hafner and Lauwers 2017;Nair and Anand 2020).…”

Do Capital Flows Matter for Monetary Policy Setting in Inflation Targeting Economies?

“…For instance, explorations on the role of exchange rates on the monetary transmission mechanism have been conducted by, among others, Taylor (2001), and Froyen and Guender (2018). Whilst studies by Bernanke and Gertler (2000), and Hafner and Lauwers (2015), among others, have investigated the central banks' responses to asset price movements. Furthermore, Taylor and Williams (2010) suggested that the exploration of alternative policy rules may need to involve the international linkages of monetary policy and the economies.…”