The Taylor Rule: A Spurious Regression?

Abstract

This paper investigates the econometric properties of the Taylor (1993) rule applied to U.S., Australian and Swedish data to judge its empirical relevance. Little attention has been paid to the time series properties of the data underlying interest rate rules, nor the estimations themselves, despite the rise in popularity of Taylor-like rules in both empirical and theoretical work. Unit root tests indicate that the variables commonly used in such modelling are likely to be integrated of order one or near integrated. Given that the variables in the Taylor rule are integrated of order one or near integrated processes, cointegration is a necessary condition both for consistent estimation of the parameters of the model and compatibility between the model and the data. Tests find little support for cointegration and, together with an out-of-sample forecast exercise, suggest that we should have serious doubts about the Taylor rule as a reasonable description of how monetary policy is conducted in the countries considered in this study. Parameter estimates from the standard Taylor rule regressions are therefore likely to be inconsistent and caution should be taken before for central bank policy is evaluated using such methods.Monetary policy; Taylor rule; Cointegration