Does the Federal Reserve Follow a Non-Linear Taylor

Abstract

The Taylor-rule has become one of the most studied strategies for monetary policy. Yet, little is known whether the Federal Reserve follows a non-linear Taylor-rule. This paper employs the smooth transition re-gression model and asks the question: does the Federal Reserve change its policy-rule according to the level of inflation and/or the output-gap? I find that the Federal Reserve does follow a non-linear Taylor-rule and, more importantly, that the Federal Reserve follows a non-linear Taylor-rule dur-ing the golden era of monetary policy, 1985-2005, and a linear Taylor-rule throughout the dark age of monetary policy, 1960-1979. Thus, good mon-etary policy is associated with a stochastically time-varying Taylor-rule: once inflation approaches a certain threshold, the Federal Reserve adjusts its policy-rule and begins to respond more forcefully to inflation.