No-Arbitrage Taylor Rules with Switching Regimes

We study the time-varying nature of U.S. monetary policies summarized by the Taylor rule based on a continuous-time regime-switching term structure model. In this model, the spot rate follows the Taylor rule and government bonds at different maturities are priced by no arbitrage. We allow the coefficients of the Taylor rule and the dynamics of inflation and output gap to be regime dependent and estimate the model using government bond yields. We find that the Fed is proactive in controlling inflation in one regime and accommodative for growth in another. Moreover, proactive monetary policies are associated with more stable inflation and output gap and therefore could have contributed to the Great Moderation. Our analysis also highlights the importance of switching regimes for term structure modeling. Without the regimes, inflation and output can explain less than 50% of the variations of bond yields. With the regimes, the two variables can explain more than 80% of the variations of bond yields.

This paper was accepted by Wei Xiong, finance.