The Central Banker as a Risk Manager: Estimating the Federal Reserve's Preferences under Greenspan

36 Pages Posted: 27 Jun 2007

See all articles by Lutz Kilian

Lutz Kilian

University of Michigan at Ann Arbor - Department of Economics; Centre for Economic Policy Research (CEPR)

Simone Manganelli

European Central Bank (ECB)

Date Written: January 2007

Abstract

Motivated by policy statements of central bankers, we propose to regard the central banker as a risk manager who aims at containing inflation and the deviation of output from potential within pre-specified bounds. We develop formal tools of risk management that may be used to quantify the risks of failing to attain that objective. Risk measures inherently depend on the loss function of the user. We propose a simple, yet flexible class of loss functions that nests the standard assumption of quadratic symmetric preferences, while being congruent with a risk management model. We show how the parameters of this loss function under weak assumptions may be estimated from realizations for inflation and output gap data even in the absence of a fully specified structural model of the economy. We present estimates of the Federal Reserve's risk aversion parameters with respect to the inflation and output objectives during the Greenspan period. We formally test for and reject the standard assumptions of quadratic and symmetric preference that underlies the derivation of the Taylor rule. Our results suggest that Fed policy decisions under Greenspan are better understood in terms of the Fed weighing upside and downside risks to their objectives rather than simply responding to the conditional mean of inflation and of the output gap. We derive a natural generalization of the Taylor rule that links changes in the interest rate to the balance of the risks implied by the dual objective of sustainable economic growth and price stability. Unlike standard Taylor rules, this generalized policy rule is consistent with the wording of policy decisions by the Federal Reserve.

Keywords: Greenspan, inflation, monetary policy, output, policy rule, preferences, risk

JEL Classification: E31, E52, E58

Suggested Citation

Kilian, Lutz and Manganelli, Simone, The Central Banker as a Risk Manager: Estimating the Federal Reserve's Preferences under Greenspan (January 2007). CEPR Discussion Paper No. 6031. Available at SSRN: https://ssrn.com/abstract=996810

Lutz Kilian (Contact Author)

University of Michigan at Ann Arbor - Department of Economics ( email )

611 Tappan Street
Ann Arbor, MI 48109-1220
United States
734-764-2320 (Phone)
734-764-2769 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Simone Manganelli

European Central Bank (ECB) ( email )

Kaiserstrasse 29
Frankfurt am Main, 60311
Germany

HOME PAGE: http://www.simonemanganelli.org

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