Taylor rules and liquidity in financial markets

Abstract

We revisit the US monetary policy history in the framework of a Taylor rule, using real-time data and market information. We find significant instability in the parameters of the Federal Reserve Bank reaction function to output gap and expected inflation. Motivated by the global financial crisis and the growing attention to financial markets, we study the role of liquidity in the interest rate rule. We estimate Markov switching models and find compliance to the Taylor principle during the high inflation period for a standard Taylor rule and consistent violations of the Taylor principle once we include proxies for liquidity. Such violations are not associated to periods of unanchored inflation.