Asset Price Momentum and Monetary Policy: Time Varying Parameter Estimation of Taylor Rules

Abstract

In this paper we consider two new independent variables as inputs to the Taylor Rule. These are the equity and housing momentum variables and are introduced to investigate the potential usefulness of these two variables in guiding the Fed to lean against potential bubbles. Such effectiveness cannot adequately be evaluated if the Taylor Rule estimation follows the standard regression methodology that has been criticized in the literature to be econometrically incorrect. Using a time varying parameter estimation methodology we find that equity momentum as an input in the Taylor Rule does not contribute to changes in Fed Funds. However, the housing momentum plays an important role econometrically and can be a useful tool in setting Fed Funds rates.

Keywords: Monetary policy rule, Nonlinear model, Stock market, Housing market, Time-varying coefficient

JEL Classification: C22, E44, G12