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Identifying a robust policy rule for the Fed's response to financial stress

Saad Ahmad

International Journal of Finance & Economics, 2020, vol. 25, issue 4, 565-578

Abstract: We seek to identify a policy rule for the Fed that remains valid in both periods of high and low financial stress. Using real‐time data, we examine traditional linear Taylor rules, Taylor rules augmented with a financial stress measure, and nonlinear Taylor rules for the Fed's response in the pre‐crisis period that lasts from 1982 to 2007. We determine that financial conditions were a significant source of nonlinearity in the Fed's response during this period, with greater volatility in the financial sector causing the Fed to prioritize the stabilisation of financial markets over its traditional policy objectives. We then extend the analysis to include the financial crisis of 2008 and find that our nonlinear Taylor rule framework also provides a plausible explanation for the Fed's conduct of monetary policy over this period. Our results, thus, show that the Fed's reaction to the recent financial crisis was not that dissimilar from its response to previous episodes of financial stress.

Date: 2020
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International Journal of Finance & Economics is currently edited by Mark P. Taylor, Keith Cuthbertson and Michael P. Dooley

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