Markov Switching and the Taylor Principle

Abstract

Early research on the Taylor rule typically divided the data exogenously into pre-Volcker and Volcker–Greenspan subsamples. We contribute to the recent trend of endogenizing changes in monetary policy by estimating a real-time forward-looking Taylor rule with endogenous Markov switching coefficients and variance. The response of the interest rate to inflation is regime-dependent, with the pre- and post-Volcker samples containing monetary regimes where the Fed did and did not follow the Taylor principle. Although the Fed consistently adhered to the Taylor principle before 1973 and after 1984, it followed the Taylor principle from 1975 to 1979 and did not follow the Taylor principle from 1980 to 1984. We also find that the Fed only responded to real economic activity during the states in which the Taylor principle held. Our results are consistent with the idea that exogenously dividing postwar monetary policy into pre- and post-Volcker samples is misleading. The greatest qualitative difference between our results and recent research employing time-varying parameters is that we find that the Fed did not adhere to the Taylor principle during most of Paul Volcker's tenure, a finding that accords with the historical record of monetary policy.

TAYLOR RULE AND DISCRETIONARY REGIMES IN THE UNITED STATES: EVIDENCE FROM Ak-STATE MARKOV REGIME-SWITCHING MODEL

“…The results also show that the low discretionary regime holds from 2008Q2 to 2014Q1. In contrast, Murray et al (2015) find a "destabilizing" Taylor rule from 1979Q4 to 1985Q1 and a "stabilizing" Taylor rule from 1985Q2 to 1989Q4. Our findings are broadly consistent with the findings of Boivin (2006) and Kim and Nelson (2006) using forward-looking TVP models.…”

“…The construction of the real time GDP deflator inflation forecast is discussed in Murray et al (2015). This series matches the four-quarter averages of median growth of the GDP deflator forecast from the SPF database accessed from the Federal Reserve Bank of Philadelphia Website.…”

“…13. Among others, Nikolsko-Rzhevskyy and Papell (2013) and Murray et al (2015) use inflation forecasts and Greenbook output gaps in examining Taylor rules.…”

“…Murray et al (2015) use data on inflation forecasts taken from the Fed's Greenbook (GB) data set updated with data from the Survey of Professional Forecasters (SPF) and two measures of real time output gaps: the first measure is taken from Orphanides (2004), based on Council of Economic Advisers (CEA) estimates updated with output gaps calculated using Congressional Budget Office (CBO) potential output, and the second measure is calculated by taking the deviations of real time real GNP/GDP from its quadratic trend.…”

“…Using revised data, they identify the 1960s, 1980s, and mid-1990s to 2007 as active monetary policy regimes and the 1970s and early 1990s as passive monetary policy regimes. Murray et al (2015) estimate a two-state Markov regime-switching model for a forward-looking Taylor rule using real time inflation forecast and real time output gaps from 1965Q4 to 2007Q4.…”