The relevance of international spillovers and asymmetric effects in the Taylor rule

Deviations of policy interest rates from the levels implied by the Taylor rule have been persistent before the financial crisis and increased especially after the turn of the century. Compared to the Taylor benchmark, policy rates were often too low. This paper provides evidence that both international spillovers, for instance international dependencies in the interest rate setting of central banks, and nonlinear reaction patterns can offer a more realistic specification of the Taylor rule in the main industrial countries. The smooth regression models suggested by Teräsvirta (1994, 1998) which we adopt provide a convenient framework to capture nonlinear dynamics in the Taylor reaction function, see Alcidi et al (2009) and Brüggemann and Riedel (2012). Compared to specifications with discrete structural breaks, these models allow for gradual change between two regimes. In the extended Taylor rule specification.

Our findings suggest that nonlinear patterns in central bank behavior can be due to several aspects. On the one hand, coefficients of the Taylor rule are different for expansionary and contractionary periods. In general, lagged changes of US interest rates are even more significant in times of increasing domestic interest rates. Hence, expansionary monetary policy decisions by the other central bank under observation have been more frequently related to changes in the US monetary policy stance. International spillovers resulting from interest rate differentials and different oil price pattern also introduce fluctuations in the Taylor reaction function coefficients. In contrast, the output gap turns out to be a less important determinant to model nonlinear dynamics.