During my recent research I thought it would be interesting to look at what different central banks say they target and what they really target. To anyone that does not study economics and reads this, you might think about skipping it. It’s probably going to get somewhat technical. Also, this is as much to find out if what I’m doing makes sense as it is to actually present some of the stuff I’ve stumbled upon.
As many papers have showed, different forms of Taylor rules have worked pretty well in the past in describing particularly the behavior of the Fed in an ex-post fashion. Taylor rules, in term, are essentially nothing else than a formula that describes a central bank’s attempt to minimize deviations from its targets. Tinkering around a bit, the following form of the Taylor rule seems to be able to explain around 95% of Fed behavior (which seems too good to be true, but combing through econometrics books has so far not forced me to assume I did something coming up with my regression results):
This isn’t too different from the basic Taylor rule. The only thing it adds is an interest rate lag, essentially the simplest way to take interest smoothing behavior into account, which has been shown many times to be important in describing Fed policy decisions. As a side note, this interest rate smoothing behavior makes it so the Taylor rule no longer obeys the Taylor principle: a rise in inflation of 1% is no longer countered by a rise in the interest rate of more than 1%. The new rule also replaces the output gap with the unemployment gap, in line with the Fed’s official mandate. Let me throw out some graphs for you below the fold. Excuse the somewhat unaesthetic presentation, I’m still coming to grips with R.