Reevaluating the Taylor Rule with Machine Learning

TL;DR

This paper reevaluates the Taylor Rule using linear regression and machine learning to better match historical federal funds rates, revealing nonlinear relationships and improving estimation accuracy.

Contribution

It introduces a machine learning approach to model the Taylor Rule, capturing nonlinear dynamics and enhancing the predictive accuracy over traditional linear methods.

Findings

Linear method overestimates output gap coefficients.

Machine learning model closely matches actual rates.

Nonlinear modeling improves estimation accuracy.

Abstract

This paper aims to reevaluate the Taylor Rule, through a linear and a nonlinear method, such that its estimated federal funds rates match those actually previously implemented by the Federal Reserve Bank. In the linear method, this paper uses an OLS regression model to find more accurate coefficients within the same Taylor Rule equation in which the dependent variable is the federal funds rate, and the independent variables are the inflation rate, the inflation gap, and the output gap. The intercept in the OLS regression model would capture the constant equilibrium target real interest rate set at 2. The linear OLS method suggests that the Taylor Rule overestimates the output gap and standalone inflation rate's coefficients for the Taylor Rule. The coefficients this paper suggests are shown in equation (2). In the nonlinear method, this paper uses a machine learning system in which the two inputs are the inflation rate and the output gap and the output is the federal funds rate. This system utilizes gradient descent error minimization to create a model that minimizes the error between the estimated federal funds rate and the actual previously implemented federal funds rate. Since the machine learning system allows the model to capture the more realistic nonlinear relationship between the variables, it significantly increases the estimation accuracy as a result. The actual and estimated federal funds rates are almost identical besides three recessions caused by bubble bursts, which the paper addresses in the concluding remarks. Overall, the first method provides theoretical insight while the second suggests a model with improved applicability.