Opportunist to risk manager: reverse engineering the Taylor rule
Byrne, Brian (2009) Opportunist to risk manager: reverse engineering the Taylor rule. PhD thesis, Dublin City University.
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Taylor (1993) advocated that the short term policy rate should respond linearly to the inflation rate and to the output gap. The Taylor Rule also seemed to track the federal funds rate over the formative years of the Greenspan regime, then considered to have experienced a number of early successes. While acknowledged as being simple and robust, the Taylor Rule does not, however, capture the nonlinearity of monetary policy as expressed by a number of Federal Reserve 'insiders'. In this thesis, the argument is made that as monetary aggregates were being de-emphasised from the early 1980s, some policy makers felt it was necessary to preserve latitude for economic shocks. From the late 1980s opportunistic monetary policy, devised by FOMC members, has been used to expound policy judgements that reflected a more discretionary posture. Chairman Greenspan also used risk management rhetoric to explain deviations from a conventional linear framework. Within this framework, discretion can be achieved by crafting the inflation forecast and the zone targeting bounds. The opportunistic reaction function as set out by Aksoy, Orphanides, Small, Wieland and Wilcox (2006) is augmented to take into account risk management perspectives using portfolio option theory. This reaction function is estimated and found to offer some improvement in describing rate decisions over a linear Taylor reaction function for the Greenspan tenure. Risk management implies policy makers pre-emptively target the expectation of inflation. Portfolio option theory is used to extend the opportunistic model as set out by Aksoy et al. (2006) and from this a number of parameter sensitivities, better known as 'the Greeks', are developed. The Greeks are used innovatively to consider how rate adjustment is likely to be affected by altering varying measures of uncertainty. In particular, delta is developed to provide a dynamic measure of interest rate inertia. Portfolio option theory and committee dynamics are also used to describe under what circumstances a linear Taylor type rule can also constitute the de facto policy rule, even for rate setting with a very defined zone target. As a consequence, the nonlinearity described by the portfolio option model is found to be highly nuanced. The impact of increasing uncertainty when policy is pre-emptive largely serves to reduce the effect of nonlinearity.
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