Multicountry Time-Varying Taylor Rule: Modeling Unconventional Monetary Policies and Bond Premiums

Abstract

AbstractIn the post-financial-crisis era, advanced economies have increasingly adopted unconventional monetary policies such as zero interest rate policy, negative interest rate policy, forward guidance communication, and international coordination policies. Consequently, the traditional Taylor rule has lost some of its explanatory power. This analysis extends the Taylor rule from a single-country to a multicountry analysis using cross-country panel data, incorporating nonmacro factors and stationary correlation in the diffusion matrix for a dynamic factor analysis, specifically covering the Group of Seven countries with datasets compiled by Bloomberg L.P. for the period 1999–2022. This approach comprehensively models these unconventional monetary policies, demonstrating greater statistical validity than existing models. Notably, the model extracts the impact of zero interest rate policy and negative interest rate policy as nonmacro factors and presents the high correlation of residuals as indicative of international coordination among central banks. Additionally, by interpreting the discrepancy between the Taylor rule and actual rate as unintended interest rate fluctuations by central banks, the study posits that interest rates will eventually return to the central bank’s intended fair value. The model’s estimation errors could be treated akin to bond value factors in global risk premia.