Department of Economics

Improving predictions of interest rate changes

The recent financial crisis has cast doubt on existing economic models used by the Central Bank

Dr Nikolaos Sakkas’ research has provided an excellent statistical procedure to overcome misspecifications when attempting to predict future interest rate changes.

Creating liquidity through monetary policy

Monetary policy is the rate of interest set by the Central Bank at which they provide liquidity to the commercial banks.

Lowering the rate injects liquidity in the economy, encourages spending and raises prices. When inflation pressures build up the Central Bank raises the interest rate making liquidity expensive, supressing spending, encouraging savings and easing inflationary pressure.

This is a simple linear relationship that relates the monetary policy instrument to the rate of inflation and the rate of unemployment or spare capacity for economic output. Higher than expected/tolerated inflation will trigger interest rate rises whilst increasing unemployment requires that the rate falls to encourage aggregate demand.

Assuming that the Central Bank attempts to stabilise the economic system around its target inflation and unemployment rates, the parameters of this linear equation represent the Central Bank’s preferences in terms of the weight they assign to achieving their targets.

 

The Taylor rule

In the last twenty years, the Taylor rule has been the model economists use to describe the behaviour of the Central Banks in the conduct of monetary policy.

 

A framework of systematic responses

The Taylor rule has provided a framework for systematic responses of the monetary authorities to incoming information on economic fundamentals as it incorporates information on both the state of prices and the real economic activity.

Due to the empirical validation, the Taylor rule equation has been incorporated into the macroeconomic models used by analysts as the most appropriate representation and forecasting tool for the reaction of the Central Bank to the arrival of macroeconomic developments.

Doubt over the stability of the Taylor rule

The recent financial crisis has cast doubt over the parameter stability implied by the Taylor rule. In response, many researchers impose a priori structural changes in the linear model based on significant events, such as financial crisis, war, or even a change in leadership of the Central Bank.

However, if such structural breaks are determined exogenously, and the specification is incorrect, this will have adverse effects on any inference based on the empirical Taylor rule. Such misspecification will result in erroneous predictions regarding the response of the Central Bank that (the predictions) will affect the volatility in the bond and probably equity markets.

It is essential to avoid such possible misspecification in attempting to predict the next monetary policy move.

Research impact

Dr Nikolaos Sakkas’ research is the development of an econometric methodology that allows for the estimation of multiple unknown structural breaks based on available data under general conditions, rather than imposing them a priori.

This methodology has been used in estimating the monetary policy response in the European area after monetary unification.

Hall, Osborn and Sakkas (2013) have pinpointed and quantified the impact of the monetary policy of the Maastricht Treaty and subsequent introduction of the Euro, and prior to that, changes in policy following the unification of Germany and the oil shocks of the early 80s.

Although they find a stable Taylor rule in the period from the monetary union until the financial crisis of 2008, they also conclude that the estimated break dates and coefficients of the Taylor rule are compatible with monetary policy changing over the various phases of European monetary integration and hence point to the inadequacy of assuming monetary policy to be constant over time.