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Taylor Rules and the Predictability of Interest Rates

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Author Info

  • Söderlind, Paul

    ()
    (University of St. Gallen)

  • Söderström, Ulf

    ()
    (Research Department, Central Bank of Sweden)

  • Vredin, Anders

    ()
    (Monetary Policy Department, Central Bank of Sweden)

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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Bibliographic Info

Paper provided by Sveriges Riksbank (Central Bank of Sweden) in its series Working Paper Series with number 147.

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Length: 25 pages
Date of creation: 01 Apr 2003
Date of revision:
Publication status: Published in Macroeconomic Dynamics, 2005, pages 412-428.
Handle: RePEc:hhs:rbnkwp:0147

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Postal: Sveriges Riksbank, SE-103 37 Stockholm, Sweden
Phone: 08 - 787 00 00
Fax: 08-21 05 31
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Web page: http://www.riksbank.com/
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Keywords: Interest rate smoothing; yield curve; survey data; VAR; in-sample overfitting;

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References

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  1. Froot, Kenneth A, 1989. " New Hope for the Expectations Hypothesis of the Term Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 44(2), pages 283-305, June.
  2. Glenn D. Rudebusch, 2000. "Assessing nominal income rules for monetary policy with model and data uncertainty," Working Paper Series 2000-03, Federal Reserve Bank of San Francisco.
  3. Lars E. O. Svensson, 2003. "What is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules," NBER Working Papers 9421, National Bureau of Economic Research, Inc.
  4. Richard Clarida & Jordi Galí & Mark Gertler, 1997. "Monetary policy rules and macroeconomic stability: Evidence and some theory," Economics Working Papers 350, Department of Economics and Business, Universitat Pompeu Fabra, revised May 1999.
  5. Refet S. Gürkaynak & Brian Sack & Eric Swanson, 2002. "Market-based measures of monetary policy expectations," Finance and Economics Discussion Series 2002-40, Board of Governors of the Federal Reserve System (U.S.).
  6. Dean Croushore, 1993. "Introducing: the survey of professional forecasters," Business Review, Federal Reserve Bank of Philadelphia, issue Nov, pages 3-15.
  7. 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.
  8. repec:nbr:nberwo:2341 is not listed on IDEAS
  9. 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.
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