9. nikolskorzhevsky kse2015

(Taylor) Rules versus Discretion in U.S. Monetary Policy

Nikolsko-Rzhevskyy et al. (2015) 11

"(Taylor) Rules Versus Discretion in U.S. Monetary Policy. Lessons for Ukraine

Alex Nikolsko-Rzhevskyy

Lehigh University

David Papell and Ruxandra Prodan

University of Houston

KSE, April 25, 2015

1



Motivation

NBU eventually has to choose how to conduct policy:

1. Policy rules

Binding plans that specify how policy will respond to

particular data such as unemployment and inflation

Example: the Taylor rule, a linear function of inflation &

output gap as proposed by John Taylor in 1993

2. Policy discretion (NBU’s and most other banks current choice)

Applied when policymakers make no commitment to future

actions, but instead make what they believe in that moment

to be the right decision for the situation



Motivation

Advantages of rules

Easily understandable by the public and markets

Solve the time-inconsistency problem. Increase credibility of

policymakers & reduce negative effects of policy tightening

on the economy (which will start eventually in Ukraine)

Eliminate inflation bias and political business cycles

(especially relevant in corrupted economies such as Ukraine)

Can decrease the probability of a policy mistake



Motivation

Advantages of discretion

Rules can be too rigid, hard to have a rule for every

possible situation

Rules do not easily incorporate the use of judgment

No one really knows what the true model of the economy is

Structural changes in the economy would lead to changes

in the coefficients of the model (the Lucas critique)

Hence, both rules and discretion have pros and cons

In this paper we test which of the two options historically lead

to better economic performance



Proposed Methodology

Divide the sample into rules-based and discretionary eras

Define Taylor rule deviations as absolute value of the

difference between the federal funds rate and the rate

prescribed by the original 1993 Taylor rule

(Taylor) rule-based eras will be low deviations

Discretionary eras will be high deviations

Test for structural breaks & Markov switching to estimate

break points and identify the regimes

Compare economic performance of the U.S. over both regimes



Taylor Rule Deviations

Original Taylor (1993) rule prescribes:

Hence, the prescribed rate is a linear function of inflation and

output gap

Construct Taylor rule deviations

Calculate actual minus prescribed federal funds rate

Take absolute value to measure deviations

The deviations are thus calculated – not estimated



Data

Real-Time Data Set for Macroeconomists (Philadelphia Fed),

described in Croushore and Stark (2001)

Data, available to policymakers at the time they were

making their decisions (“snapshots” of the economy)

Shown by Orphanides (2001) and many others to be

necessary for policy evaluation due to frequent revisions

Vintages starting in 1965:Q4

Data within each vintage starts in 1947:Q1

GDP/GNP and GDP/GNP Deflator



Data



Taylor Rule Deviations



Estimation

Recall, our first goal is to identify periods of large (“discretion”)

and small (“rules”) deviations

Hence, we need to test the deviations series for possible

regime changes

To identify the eras, we use 2 different estimation techniques

Bai and Perron (1998, 2003) sequential test for multiple

structural changes

Markov Switching Hamilton (1989) two-regime model



Markov Switching Models

Recall, our first goal is to identify periods of large (“discretion”)

and small (“rules”) deviations

We use Markov Switching Hamilton (1989) two-regime model

Allow for changes in the:

Mean µ and variance σ2ε of the Taylor Rule deviations dt

Estimate transition probabilities P[s=1|1] and P[s=2|2]

Rules-based eras: lower mean and variance (smaller µ & σ2ε)

Discretionary eras: higher mean and variance



Both estimated means and standard deviations are clearly

different between the states; states are quite persistent

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: Switching Mean and Variance



Proposed Loss Functions

The next step is to compare economic performance of the

U.S. over both regimes

Calculate loss functions for rules-based & discretionary eras

1. Okun’s Misery Index

(Inflation + Unemployment)

2. Linear absolute loss function

|inflation - 2%| + |unemployment rate - natural rate|

3. Quadratic loss function

(inflation - 2%)2 + (unemployment rate - natural rate)2



Loss Functions

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 Loss Function L = |Inflation - 2%| + |Unemployment - Natural Rate|



Panel C: Quadratic Loss Function L = (Inflation - 2%)2 + (Unemployment - Natural Rate)2



5.0

5.0



Monetary policy rules work and discretion doesn’t

This effect should be even more pronounced for developing

countries where rules offer additional benefits (reduce

corruption & political influence of government on the bank)

How to implement rules in practice?

Verkhovna Rada would have to legislate the NBU’s

commitment to rules, thus penalizing deviations; otherwise,

using rules will not be different from exercising discretion

A good starting point could be the U.S. Federal Reserve

Accountability and Transparency Act of 2014.

Findings & Policy Implication for Ukraine



Findings & Policy Implication for Ukraine

The “Federal Reserve Accountability and Transparency Act of

2014″, introduced into Congress on July 7, 2014

Requires the Fed to choose & adopt a “Directive Policy Rule”

The rule should not necessarily be a Taylor rule

While this “Directive Policy Rule” can change in time, the

changes would have to be justified & explained

If the Fed deviated from its rule, the Chair of the Fed would

have to testify before the appropriate congressional committee



Thank you!



Motivation

What do policymakers think about these two choices?

The Fed (as the vast majority of central banks) is using

discretion and has never formally used rules to guide

monetary policy

They would prefer to keep using discretion, i.e. have

freedom

The Congress seems to lean towards rules and would prefer

to limit the Fed’s independence

Several new initiatives followed the latest crisis that are

aimed at limiting the Fed’s independence



Markov Switching Models: Robustness Checks

A simple two state model with simultaneously switching mean

and variance might be unwarranted

Possible concerns: There were no switches or the switches

occurred only in variance and that what drives the results

(Sims and Zha, AER 2004)

Hence, we estimate two more versions of this model

1. Switching Mean, Variance forced to stay constant

2. Switching Mean and Independently Switching Variance



Both means are still clearly different

Markov Switching Model: Switching Mean, Constant Variance

00112233

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



Both means and standard deviations are clearly different

between the states. The state distribution stays the same.

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 (top) and Variance (bottom)

9. nikolskorzhevsky kse2015

Presentations & Public Speaking

situation taylor rules

regimes taylor rules

policy mistake taylor

taylor rule estimation

john taylor

realtime data taylor

policy discretion nbus

policy rules binding