Time-varying Policy Targets and Regime Switches in U.S. Monetary Policy

The central bank’s monetary policy targets are usually assumed to be constant overtime for simplicity when estimating a Taylor rule, but recent studies have shed some light on the time variation in policy targets, especially in the inflation target. The potential bias due to misspecification of the time variation can be quite considerable, especially in regime-swtiching models. In this paper, we examine the evidence of regime switches in coefficients of the Taylor rule under two assumptions of policy targets: constant and time-varying. Based on Bayesian model comparison, we find strong statistical evidence in favor of regime switches in coefficients of the Taylor rule assuming constant policy targets. However, once we incorporate time-varying policy targets, the constant coefficient Taylor rule is strongly preferred by U.S. data. Our empirical results point to the conclusion that there is no evidence in favor of regime switches in U.S. monetary policy beyond that implied by time-varying policy targets. JEL-Classification: C11, C32, C52, E52.