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Taylor Rules and the Predictability of Interest Rates

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  • Söderlind, Paul
  • Söderström, Ulf
  • Vredin, Anders

Abstract

Recent research suggests that commonly estimated dynamic Taylor rules augmented with a lagged interest rate imply too much predictability of interest rate changes compared with yield curve evidence. We show that this is not sufficient proof against the Taylor rule: the result could be driven by other equations of the model that the Taylor rule is embedded in. To disentangle the effects, we study the predictability of all variables in a simple model of monetary policy: inflation, the output gap, and the interest rate, and we compare with evidence from survey data and a VAR model. We find that the strongest evidence against the Taylor rule is that while it is easy to predict the variables that enter the rule, it is very hard to predict actual interest rate changes. This is consistent with usual Taylor-type rules if policy shocks are very large, but it is more likely that there are other aspects of monetary policy behaviour that are neglected by the Taylor rule.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 3934.

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Date of creation: May 2003
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Handle: RePEc:cpr:ceprdp:3934

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Keywords: in-sample overfitting; interest rate smoothing; survey data; VAR; yield curve;

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  1. Rudebusch, Glenn D., 2000. "Assessing nominal income rules for monetary policy with model and data uncertainty," Working Paper Series 0014, European Central Bank.
  2. Gurkaynak, Refet S. & Sack, Brian T. & Swanson, Eric P., 2007. "Market-Based Measures of Monetary Policy Expectations," Journal of Business & Economic Statistics, American Statistical Association, vol. 25, pages 201-212, April.
  3. Shiller, Robert J. & Huston McCulloch, J., 1990. "The term structure of interest rates," Handbook of Monetary Economics, in: B. M. Friedman & F. H. Hahn (ed.), Handbook of Monetary Economics, edition 1, volume 1, chapter 13, pages 627-722 Elsevier.
  4. Richard Clarida & Jordi Galí & Mark Gertler, 2000. "Monetary Policy Rules And Macroeconomic Stability: Evidence And Some Theory," The Quarterly Journal of Economics, MIT Press, vol. 115(1), pages 147-180, February.
  5. Jeffrey C. Fuhrer, 2000. "Habit Formation in Consumption and Its Implications for Monetary-Policy Models," American Economic Review, American Economic Association, vol. 90(3), pages 367-390, June.
  6. Kenneth A. Froot, 1987. "New Hope for the Expectations Hypothesis of the Term Structure of Interest Rates," NBER Working Papers 2363, National Bureau of Economic Research, Inc.
  7. Lars E. O. Svensson, 2003. "What Is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules," Journal of Economic Literature, American Economic Association, vol. 41(2), pages 426-477, June.
  8. repec:nbr:nberwo:2341 is not listed on IDEAS
  9. Dean Croushore, 1993. "Introducing: the survey of professional forecasters," Business Review, Federal Reserve Bank of Philadelphia, issue Nov, pages 3-15.
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