Identifying a robust policy rule for the Fed's response to financial stress

Abstract

We seek to identify a policy rule for the Fed that remains valid in both periods of high and low financial stress. Using real-time data, we examine traditional linear Taylor rules, Taylor rules augmented with a financial stress measure, and nonlinear Taylor rules for the Fed's response in the pre-crisis period that lasts from 1982 to 2007. We determine that financial conditions were a significant source of nonlinearity in the Fed's response during this period, with greater volatility in the financial sector causing the Fed to prioritize the stabilisation of financial markets over its traditional policy objectives. We then extend the analysis to include the financial crisis of 2008 and find that our nonlinear Taylor rule framework also provides a plausible explanation for the Fed's conduct of monetary policy over this period. Our results, thus, show that the Fed's reaction to the recent financial crisis was not that dissimilar from its response to previous episodes of financial stress.

Re-Examining the South African Reserve Bank’s Policy Reaction Function Using the NARDL Model

“…Since its inception, the policy reaction function has undergone numerous modifications ranging from the 'forward-looking' or 'rationaleexpectations-based' Taylor rule (Clarida, Gali, and Gertler 1998;Orphanides 2002) to augmentations with real exchange rates (Svensson 2003;Engel and West 2006;Wilde 2012;Chen, Yao, and Ou 2017), asset prices (Chadha, Sarno, and Valente 2004;Morley and Wei 2012;Finocchiaro and Heideken 2013) and financial conditions (Baxa, Hoorvath, and Vašíček 2013;Nair and Anand 2020;Ahmad 2020), to nonlinear policy reaction functions due to asymmetric policy preferences or asymmetries in monetary-macroeconomic relationships such as the Aggregate Supply or Phillips curve (Orphanides and Wieland 2000;Orphanides and Wilcox 2002;Nobay and Peel 2003;Schaling 2004;Dolado, Pedrero, and Ruge-Murcia 2004;Surico 2007;Cukierman and Muscatelli 2008;Castro 2011;Koustas and Lamarche 2012;Zu and Chen 2017). Notably, many of these modified Taylor policy rules have been estimated exclusively using South African data and this has resulted in a variety of empirical fits of the sarb policy reaction function (Aron and Muellbauer 2000;Klein 2012;Ncube and Tshuma 2010;Naraidoo and Gupta 2010;Naraidoo and Raputsoane 2010;Naraidoo and Paya 2012;Baaziz, Labidi, and Lahiani 2013;Bold and Harris 2018).…”

“…For instance, Yellen (2012) prescribes modified policy rules with quantitative easing and forward guidance for us monetary authorities. More recently, Ahmad (2020) has proposed that the us policy reaction rule be modified such that policy rates respond 'two-for-one' with inflation deviations. However, for the case of the sarb, whose interest rates are well above the zero lower bound, such policy prescriptions may be unwarranted for the central bank.…”