(Taylor) Rules versus Discretion in U.S. Monetary Policy Alex Nikolsko-Rzhevskyy Lehigh University David Papell and Ruxandra Prodan University of Houston Texas Camp Econometrics – February 22, 2014

Motivation Monetary Policy Rules Rules versus Discretion Taylor Rule Friedman (1960) Rules versus Discretion Kydland and Prescott (1977) Taylor Rule Taylor (1993)

“Monetary Policy Rules Work and Discretion Doesn’t: A Tale of Two Eras” Taylor (2012) JMCB Lecture The Rules-Based Era 1985-2003 The Ad Hoc (or Discretionary) Era 2003 - ? Chose Eras Based on Historical Experience Temptation – Choose Eras Based on Success or Failure Good Outcomes Become Rules-Based Eras Bad Outcomes Become Ad Hoc Eras

Plan for the Paper Identify Rules-Based and Discretionary Eras from the Data Not Influenced by Economic Outcomes Define Taylor Rule Deviations Absolute Value of the Difference Between the Federal Funds Rate and the Rate Prescribed by the Original Taylor Rule (Taylor) Rule-Based Eras Lower Deviations Discretionary Eras Higher Deviations Tests for Multiple Structural Changes Markov Switching Models

Taylor Rule Deviations Original Taylor (1993) Rule it = pt + 1.5 (pt – 2.0) + 0.5 yt + 2.0 it = 1.0 + 1.5 pt + 0.5 yt Construct Taylor Rule Deviations Calculate Actual Minus Prescribed Federal Funds Rate Take Absolute Value to Measure Deviations The Deviations are Calculated – Not Estimated

Data Real-Time Data Set for Macroeconomists (Philadelphia Fed) GDP and GDP Deflator Vintages Starting in 1965:Q4 – Data Starts in 1947:Q1 Inflation Annual Percentage Change in GDP Deflator Can’t Get Long Series for Other Measures

Data Output Gap Policy Rate No Internal Fed (Greenbook) Output Gaps Before 1987 Real-Time Detrending Starting in 1947:Q1 Linear, Quadratic, and Hodrick-Prescott Detrending No Necessity for Positive and Negative Output Gaps to be Equal Policy Rate Federal Funds Rate Until 2008:Q4 Shadow Federal Funds Rate Starting in 2009:Q1 Shadow Rate Term Structure Model of Wu and Xia (2013)

Real-time output gaps using linear, quadratic, and HP detrending

Real-Time Output Gaps Linear Detrending HP Detrending Consistently Negative Since 1974 HP Detrending Gaps Too Small During the 1970s and Early 1980s Recessions Real-Time Okun’s Law Metric Gaps for the 1990 and 2001 Recessions Almost as Large as Gaps for the 1980 and 1982 Recessions Quadratic Detrending Fits Gaps for 1970s and 1980s Recessions Reasonable for 1980s through 2000s and 2009-2013

Taylor Rule Deviations Real-Time GDP Inflation Real-Time Quadratic Detrended Output Gaps Negative in the 1970s Positive in the Early 1980s Negative in the 2000s

The Federal Funds Rate and the Prescribed Taylor Rule Rate

The Difference Between the Actual and Prescribed Rates

Taylor Rule Deviations

Structural Change Tests Bai and Perron (1998) Tests for Multiple Structural Breaks Changes in the Mean of the Taylor Rule Deviations Dt = g0 + g1DU1t +…+gmDUmt + ut Dt are Taylor Rule Deviations DUmt = 1 if t>Tbt, 0 Otherwise, for All Breakpoints Tbt sup Ft (l+1/l) Test with 15% Trimming Search for a Break, Split Sample, Search Sub-Samples

Structural Change Tests SupF test (sequential method) Critical values (1%) Break dates 95% Confidence Intervals SupF(1| 0) = 32.63 12.29 1985:Q1 1984:Q4 - 1986:Q2 SupF(2| 1) = 53.27 13.89 2000:Q4 1999:Q2 - 2001:Q2 SupF(3| 2) = 50.74 14.80 1974:Q3 1972:Q3 - 1975:Q2 Coefficients γ0 = 1.468 γ1 = 1.835 γ2 = -2.506 γ3 = 1.174

Structural Change Tests

Structural Change Tests Mean of the Taylor Rule Deviations 1.47 for 1965:Q4 – 1974:Q3 3.30 for 1974:Q4 – 1985:Q1 0.80 for 1985:Q2 – 2000:Q4 1.97 for 2001:Q1 – 2013:Q4 Highest in the 1970s and Early 1980s Lowest in the Great Moderation

Restricted Structural Change Tests Bai and Perron Tests do Not Determine Whether the Two Higher Means are Statistically Different from the Two Lower Means Perron and Qu (2006) Tests Add Two Constraints to Bai and Perron test g1 + g2 = 0 and g2 + g3 = 0

Restricted Structural Change Tests Restricted SupF test Critical value (1%) Break dates 95% Confidence Intervals 85.46* 17.17 1974:Q3 1971:Q1 - 1975:Q3 1985:Q1 1984:Q4 - 1988:Q3 2001:Q1 1999:Q1 - 2001:Q3 Coefficients γ0 = 1.075 γ1 = 1.531 γ2 = -1.531 γ3 = 1.531

Restricted Structural Change Tests Same Break Dates as in Bai and Perron Mean of the Taylor Rule Deviations 1.05 for 1965:Q4 – 1974:Q3 and 1985:Q2 – 2001:Q1 2.58 for 1974:Q4 – 1985:Q1 and 2001:Q2 – 2013:Q4 Rules-Based and Discretionary Eras The Differences are Statistically Significant

Structural Change Tests with Inflation Forecasts Greenbook Inflation Forecasts Instead of Inflation Rates Four-Quarter-Ahead Forecasts Available from 1973:Q3 – 2007:Q4 SPF Forecasts for 2008:1 – 2013:4

Structural Change Tests with Inflation Forecasts SupF test (sequential method) Critical values (1%) Break dates 95% Confidence Intervals SupF(1| 0) = 53.17* 12.29 1984:Q3 1983:Q2 - 1986:Q4 SupF(2| 1) = 42.36* 13.89 2001:Q1 1998:Q2 - 2002:Q1 Coefficients γ0 = 3.182 γ1 = -2.363 γ2 = 0.893

Structural Change Tests with Inflation Forecasts

Markov Switching Models Two State Models Similar to the Restricted Structural Change Model Allow for Changes in the: Mean and Variance of the Taylor Rule Deviations Transition Probabilities Rules-Based Eras Lower Mean and Variance Discretionary Eras Higher mean and Variance

Markov Switching Model: Switching Mean and Variance   State s=1 (Rules-Based) State s=2 (Discretionary) μs 0.781 2.779 (0.070) (0.137) σs 0.548 1.177 (0.052) (0.089) pss 0.942 0.952 (0.026) (0.024)

Markov Switching Model: Switching Mean and Variance Similar Regime Switches to Structural Change Break Dates First Rules-Based Era Ends in 1974:Q3 Discretionary Era from 1974:Q4 – 1986:Q1 Rules-Based Era from 1986:Q2 – 2001:Q1 Discretionary Era from 2001:Q2 – 2006:Q2 Additional Regime Switches Discretionary Era from 1965:Q4 – 1968:Q4 Rules-Based Era from 2006:Q3 – 2007:Q4 Discretionary Era from 2008:Q1 – 2009:Q1 Rules Based Era from 2009:Q2 - 2011:Q1 Discretionary Era from 2011:Q2 – 2013:Q4 No Trimming with Markov Switching Models Discretionary Eras When Deviations > Two Percent

Markov Switching: Switching Mean and Variance

Markov Switching Model: Switching Mean, Constant Variance   State s=1 (Rule-based policy) State s=2 (Discretion) μs 1.050 3.202 (0.103) (0.175) σs 0.896 (0.051) pss 0.916 0.957 (0.043) (0.021)

Markov Switching: Switching Mean, Constant Variance

Markov Switching Model: Switching Mean and Independently Switching Variance   State s=1 (Rule-based policy) State s=2 (Discretion) μs 0.786 2.492 (0.069) (0.089) σs 0.598 2.089 (0.039) (0.350) pmeanss 0.985 0.906 (0.203) (0.303) pvarss 0.946 0.942 (0.161) (0.155)

Markov Switching: Independently Switching Mean and Variance

Historical Perspective Taylor and Meltzer 1985 – 2003 a Rules-Based Era 2003 – 2012 a Discretionary Era 1985 Start of the Rules-Based Era Accords with our Results We Date the Start of Discretionary Era as 2001 Clear from the Taylor Rule Deviations Is This Caused by our Data and/or Detrending? Same Result from Poole (2007) Diagram in Taylor (2012) Deviations Start in 2001 Become Larger Starting in 2003

Taylor Rule Deviations

Updated Poole (2007) Diagram

Historical Perspective Rules-Based Era from 2006:Q3 – 2007:Q4 Taylor (2007) Actual and Prescribed Paths Diverge in 2002:Q2 and Converge in 2006:Q3 Discretionary Era from 2008:Q1 – 2008:Q4 Response to Financial Market Stress Taylor (2008) Proposed Lowering FFR by LIBOR-OIS Spread Discretionary Era from 1965:Q4 – 1968:Q4 Change from Johnson to Nixon Administration Discussed in Taylor’s First Principles Book

“Monetary Policy Rules Work and Discretion Doesn’t” Taylor’s Assertion Evaluate with Our Results Use Revised Data on Inflation and Unemployment Calculate Loss Functions for Rules-Based and Discretionary Eras Okun’s Misery Index (Inflation Plus Unemployment) Linear absolute loss function |inflation - 2%|+|unemployment rate - natural rate| Quadratic loss function (inflation - 2%)2+(unemployment rate - natural rate)2

Inflation and Unemployment

Loss Functions Average Loss During Taylor-Rule Eras   Average Loss During Taylor-Rule Eras Average Loss During Discretionary Eras Panel A: Misery Index L = Inflation + Unemployment Markov Switching 8.74 10.83 Structural Change 8.52 11.11 Panel B: Linear Absolute Loss Function L = |Inflation - 2%| + |Unemployment - Natural Rate| 2.37 3.87 2.32 3.95 Panel C: Quadratic Loss Function L = (Inflation - 2%)2 + (Unemployment - Natural Rate)2 5.91 14.86 5.10 15.91

Loss Functions Average Loss During Taylor-Rule Eras   Average Loss During Taylor-Rule Eras Average Loss During Discretionary Eras Panel A: Misery Index L = Inflation + Unemployment Markov Switching 9.70 9.89 Structural Change 9.41 10.63 Panel B: Linear Absolute Loss Function L = |Inflation - 2%| + |Unemployment - Natural Rate| 2.80 3.55 2.90 3.61 Panel C: Quadratic Loss Function L = (Inflation - 2%)2 + (Unemployment - Natural Rate)2 8.71 12.65 8.49 14.72

Identify (Taylor) Rules-Based and Discretionary Eras Conclusions Identify (Taylor) Rules-Based and Discretionary Eras Tests for Structural Change and Markov Switching Methods Our Statistical Results Provide Support for Taylor’s Results The Dates Closely Correspond Not Subject to Being Influenced by Outcomes Different Perspective on Start of the Recent Discretionary Era 2001 Instead of 2003 Validated by Poole’s Diagram Monetary Policy Rules Work and Discretion Doesn’t