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Journal of Economics and Finance

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01-01-2013

The Fed’s TRAP

A Taylor-type rule with asset prices

Authors: Alexander Erler, Christian Drescher, Damir Križanac

Published in: Journal of Economics and Finance | Issue 1/2013

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Abstract

The article examines if US monetary policy implicitly responds to asset price booms. Using real-time data and a GMM framework we estimate a Taylor-type rule with an asset variable that captures phases of booms and busts in the real estate market. We identify quasi real-time booms and busts using an asset cycle dating procedure. Our analysis yields two main findings. Firstly, the Fed does implicitly respond to asset price booms in the real estate market. Secondly, these responses are typically pro-cyclic and their intensity changes over time.

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Consumer price inflation is approximated by changes in the Consumer Price Index for all urban consumers including all items. Changes in corporate equity prices are generated from the S&P 500 Index and those of real estate prices stem from the FHFA Index.

The “paradox of credibility” states that a credible monetary policy can induce boom and bust cycles in asset markets. It implies that the anchoring of inflation expectations for consumer markets at reasonable levels will head excess liquidity to asset markets.

On principle Taylor-type rules can either be applied in a prescriptive way, that sets recommendations on how central banks should act, or in a descriptive way, in order to examine the interest rate setting behavior of central banks.

It is crucial to note, that we do not refer to asset price bubbles.

Deflated asset prices indicate the development of relative prices between the asset in question and the underlying consumer basket. The applied consumer price index (all items) is used as a proxy for economy-wide price developments.

In general, asset price cycles are subject to less rigidities and frictions than real business cycles are. For instance, real markets are often characterized by sticky prices, whereas asset prices usually respond more quickly.

In the short-term, most asset markets, such as the real estate market, have a relative inelastic supply since the asset supply can often not be adjusted without some lag of time. For instance, the supply of houses can increase only gradually since the building of an house requires time. In the long-term, the supply curve is more elastic.

The Bry–Boschan cycle dating procedure is a non-parametric technique for dating real business cycles, but is for example also used to identify asset price cycles in corporate equity markets (see, e.g., Edwards et al. 2003; Kaminsky and Schmukler 2003; Pagan and Sossounov 2003; Biscarri and Gracia 2004; Gonzalez et al. 2005).

The original Taylor rule is given by r = p + 0.5y + 0.5(p − 2) + 2, where r is the federal funds rate, p is a proxy for the expected inflation rate and y is the output gap. The inflation target and long-term real interest rate are assumed to be constant and appraised to be 2 (Taylor 1993).

Since the equilibrium real interest rate is an unobserved variable it needs to be estimated. Our estimations build on the economic postulate that in a market equilibrium real interest rates should be conform with the economy’s marginal productivity of capital.

Reasons and consequences of a time-varying inflation target are given by Ireland (2007).

As it is common with data that come with a quarterly frequency the smoothing parameter is chosen to be λ = 1,600 (see, e.g., Baxter and King 1995).

The first five forecasts are taken from the Philadelphia Fed’s real-time data set. The optimal lag length of the autoregression is determined by step-wise least squares estimations with a maximum lag length of 8 and approved p-values up to 10%.

By definition, explanatory variables x _t are said to be endogenous if they are correlated with the equation’s error term ϵ _t.

The high correlation between the own realizations reduce the standard errors compared with other less correlated variables (see Wooldridge 2002, p. 101). The GMM provides the additional benefit that it also accounts for measurement uncertainties to which our estimation could be subject to.

The installation of unconventional measures makes it hard to estimate reasonable parameters for Taylor-type rules.

Variations in the smoothing parameter of the HP filter do not substantially change our main results with respect to the sign and significance level.

Due to small samples either the two step GMM procedure is applied or if possible the optimal weighting matrix is used to obtain the iterated GMM estimator.

‘Effective’ refers to the product of the asset cycle coefficient ϕ and (1 − ρ), whereas ρ describes the interest rate smoothing parameter.

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Title: The Fed’s TRAP
A Taylor-type rule with asset prices
Authors: Alexander Erler
Christian Drescher
Damir Križanac
Publication date: 01-01-2013
Publisher: Springer US
Published in: Journal of Economics and Finance / Issue 1/2013
Print ISSN: 1055-0925
Electronic ISSN: 1938-9744
DOI: https://doi.org/10.1007/s12197-011-9173-z

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