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

• Published date: 01 October 2020
• DOI: http://doi.org/10.1002/ijfe.1766
• Author: Saad Ahmad
• Date: 01 October 2020

Received: 16 March 2017 Revised: 29 January 2019 Accepted: 13 September 2019

DOI: 10.1002/ijfe.1766

RESEARCH ARTICLE

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

financial stress

Saad Ahmad

U.S. International TradeCommission,

Wash ingto n, DC, US A

Correspondence

Saad Ahmad, U.S. International Trade

Commission, Washington, DC, USA.

Email: saad.ahmad@usitc.gov

Abstract

We seek to identify a policy rule for the Fedthat remains valid in both periods of

high and low financial stress. Using real-time data, we examine traditionallinear

Taylor rules, Taylor rules augmented with a financial stress measure, and non-

linear 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 finan-

cial 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 mon-

etary 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.

KEYWORDS

Federal reserve, financial crisis, nonlinearity, real-time data, Taylorrule

MSC CLASSIFICATION

C53; E47; E52

1INTRODUCTION

The last century has seen a remarkable evolution in the

central banks' role as they have taken on a greater respon-

sibility for a country's economic and financial well-being.

The global financial crisis of 2008, however, greatly tested

the ability of central banks to manage economic funda-

mentals through traditional monetary policy tools. The

Fed, led by Ben Bernanke, decided to undertake dras-

tic, and often unprecedented, steps to counter the effects

of this financial crisis. These included bailing out finan-

cial firms like Bear Stearns and AIG, establishing pro-

grammes for direct provision of credit to both financial and

non-financial institutions and pursuing quantitative eas-

ing through large-scale asset purchases once the policy rate

reached the zero lower bound.1

Considerable debate exists on whether the Fed's

response during the recent financial crisis was a sharp

departure from it's traditional conduct of monetary policy

and the Taylor rule (Taylor, 1993). In policy discussions,

the Taylor rule, or some variant of it, is often used to pro-

vide a simple benchmark to determine if a central bank

is following a rules-based or discretionary approach in

setting the policy rate.2Rudebusch (2009) finds that the

implied rate using the original Taylor rule for this period

was around −5%, thus justifying the Fed's unconven-

tional approach to the crisis. Taylor (2010), conversely,

finds implied rates from the original Taylor rule to be

between 0.75% and −0.75%, leading him to critique the

Fed's quantitative easing programmes as harmful devia-

tions from rules-based monetary policies (Taylor, 2011).

Nikolsko-Rzhevskyy and Papell (2013) analyse Fed policy

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Int J Fin Econ. 2020;25:565–578. wileyonlinelibrary.com/journal/ijfe © 2019 John Wiley & Sons, Ltd. 565