Nonlinearity and structural breaks in monetary policy rules with stock prices

a r t i c l e i n f o JEL classification: E31 E44 E52 Keywords: Monetary policy rule Nonlinear model Stock market Structural break Time-varying coefficient This paper introduces nonlinearity and a structural break to the US forward-looking Taylor rule with a stock price gap, thereby alleviating the robustness problem that the linear Taylor rule is sensitive to minor changes of the sample period since 1991. The path of the time-varying inflation coefficient shows that, unlike in the linear model, the Fed consistently responds to inflationary pressures in an aggressive manner even after 1991. The stock price coefficient stays positive since 1991. However, its time-varying pattern does not show active responses in the early periods of stock price hikes, which is counter to the view that the Fed has preemptively reacted to stock price bubbles. Modeling how monetary policy changes in response to economic circumstances has long been an interesting topic in macroeconomics, for various reasons. The policy reaction function is an important element in macroeconomic models, which helps to forecast changes in the federal funds target rate, plays an important role in evaluating the Federal Reserve's monetary policy, and provides a better understanding of various macroeconomic issues. Robust estimation of the Fed's reaction function is consequently of central importance in empirical macroeconomic analysis. This paper has two objectives. The first is to examine the Fed's response to stock prices, as well as expected inflation, using a forward-looking interest rate rule with addition of a stock price variable. The role of stock prices in the setting of monetary policy has long been an important issue, both in policy making and in academic research. The current research focuses on two questions: 1) should the Fed respond to a stock price change? and 2) has the Fed responded to stock price changes? This paper does not attempt to answer the first question. For detailed discussion, however, see Bernanke and Gertler (1999, 2001) for the standard policy view that, before a bubble collapses, monetary policy should consider changes in stock prices only when they are strongly associated with future inflation expectations. See also Cecchetti et al. the alternative policy view that the central bank should preemptively respond to non-fundamental stock price changes to obtain macroeconomic and financial stability. In this paper we focus on the second question, that is, we examine whether and how the federal funds target rate has moved …