Is the Taylor Rule Nonlinear? Empirical Evidence from a Semi-Parametric Modeling Approach

This paper investigates the empirical specification of the Taylor Rule. Building on the New Keynesian paradigm, we derive a general nonlinear specification for the optimal policy rule that nests the standard linear Taylor Rule as a particular case. Using a novel semi-parametric modeling approach, we estimate both a standard and an augmented specification of the Taylor Rule for 8 OECD countries over the period 1976-2010 within a quarterly frequency. The augmented specification includes an interaction term between economic fundamentals and accounts explicitly for the interaction between economic fundamentals and the business cycle. The empirical results first point to a strong evidence for nonlinearity in the Taylor Rule for all countries. Second, our augmented specification outperforms both the standard linear and nonlinear Taylor Rules as it fits better the actual policy rate. Third, the performance of the augmented semi-parametric Taylor Rule is similar to the one of a linear policy rule with interest rate smoothing. An out-of-sample forecasting of the policy rate indicates that the nonlinear specification clearly outperforms the linear Taylor Rule for all countries using two different forecasting procedures and two measures of the economic outlook. The nonlinear interest rate rule thus provides an accurate guideline for the Central Bank decisions on the key interest rate, while at the same time avoids a possible misspecification problem that might arise when using interest rate smoothing in the policy rule.