Nonlinear interest rate reaction functions for the UK

We empirically analyze Taylor-type equations for short-term interest rates in the United Kingdom using quarterly data from 1970Q1 to 2006Q2. Starting from strong evidence against a simple linear Taylor rule, we model nonlinearities using logistic smooth transition regression (LSTR) models. The LSTR models with time-varying parameters consistently track actual interest rate movements better than a linear model with constant parameters. Our preferred LSTR model uses lagged interest rates as a transition variable and suggests that in times of recessions the Bank of England puts more weight on the output gap and less so on inflation. A reverse pattern is observed in non-recession periods. Parameters of the model change less frequently after 1992, when an inflation target range was announced. We conclude that for the analysis of historical monetary policy, the LSTR approach is a viable alternative to linear reaction functions.

Research Highlights►We empirically analyze nonlinearities in interest rate reaction functions for the UK. ►We find strong evidence against a simple linear Taylor rule. ►Parameter changes are modeled using logistic smooth transition regressions. ►In recessions the BoE puts more weight on output gap and less on inflation. ►Model parameters change less often after inflation target was announced in 1992.