Anticipating Monetary Policy with the Federal Reserve's Beige Book: Re-specifying the Taylor Rule

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Author: David R. Payne
Date: Jan. 2001
From: Business Economics(Vol. 36, Issue 1)
Publisher: Springer
Document Type: Brief article
Length: 5,655 words

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A re-specification of the popular Taylor Rule for monetary policy shows that both manufacturing capacity utilization and an index created from the Beige Book contribute significantly to predicting changes in the federal funds interest rate, more than traditional estimates of deviations from potential GDP. The Beige Book Index is also helpful in predicting revisions to the indexes of leading and coincident indicators, showing that it may initially be the more reliable broad-based indicator.

Business economists often have reasons to try to anticipate Federal Reserve monetary policy actions. The "Taylor Rule" [1] is a simple and commonly used means of anticipating these actions. It postulates that Federal Reserve policy makers react both to realized inflation and to output that is above or below its non-inflationary potential. Output growth is a target because when it is stronger than its potential, inflationary pressures build, and when weaker, excess unemployment results. The Taylor Rule has been used both to predict and to evaluate Fed actions. It is expressed as: [i.sub.t] = [[pi].sub.t]+[r.sup*]+0.5([[pi].sub.t] - [[pi].sup.*])+0.5([y.sub.t])

where i = federal funds rate

[r.sup.*] = equilibrium real federal funds rate

[pi] = average inflation rate over the contemporaneous and prior three quarters

[[pi].sup.*] = target inflation rate

y = output gap ([100.sup.*](real GDP-potential GDP)/potential GDP)

While a number of studies have noted past problems in its application, [2] and criticized its neglect of forecast information, Judd and Rudebusch (1998) report: "simple Taylor-type reaction functions (how the Fed alters monetary policy in response to economic developments) were found to perform almost as well as optimal, forecast-based reaction functions that incorporate all the information available in the models examined. In addition, the simple specification was found to perform almost as well as reaction functions that explicitly include a variety of additional variables. These results appear to be fairly robust across a variety of macroeconomic models. Thus, the general form of the Taylor Rule may be a good device for capturing the key elements of policy in a variety of policy regimes." [3]

The Taylor Rule-type approach should work well for the business economist who wants a simple method to anticipate interest rate changes initiated by the Federal Reserve, because it links those changes directly to available data rather than model forecasts. The main result of this paper is that when applying the Taylor Rule, changes in the federal funds interest rate (the rate most influenced by the Fed) are better explained by the manufacturing capacity utilization rate and an index derived from the Fed's Beige Book than by traditional estimates of deviations from potential GDP. (The "Beige Book" is the popular name given to the Federal Reserve's anecdotal survey of conditions in each of the twelve Federal Reserve bank districts. The survey is conducted eight times a year, and the Beige Book is released about two weeks prior to meetings of the Federal Reserve Open Market Committee, or FOMC.) [4]

It is easy to see why the Fed might...

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Gale Document Number: GALE|A71712039