UK Monetary Policy Reaction Functions, 1992-2014: A Cointegration Approach Using Taylor Rules.

For more than two decades, monetary policy of countries around the world has undergone significant transformation. The long-term stabilization and lowering of inflation is the primary target of central banks founded on the principles of transparency and credibility. The achievement of inflation targeting and control is ultimately judged by the public’s expectations about future inflation. This objective has focused central bank policy making on modern monetary principles and the adoption of one of its core principles, the monetary policy rule.
The central bank of the United Kingdom officially adopted an explicit inflating targeting monetary policy in October 1992 following its operational independence in May 1997. In this study, we attempt to investigate the behaviour of the Central Bank of England under an inflation targeting framework. In other words, whether Taylor-type policy rules can be used to describe the behaviour of the Central Bank of England. We specifically attempt to shed light on the question does Taylor's rule (Taylor, 1993) adequately describes central bank behaviour? And whether the existence of formal targets has induced nonlinearity in this behaviour, beginning in October 1992 until December 2014.
The study uses time series estimations of Taylor-type reactions functions to characterise monetary policy conduct in the UK, we use time series data, because all the other studies in this area are using the time series method and recommended it, Osterholm (2005), Nelson (2000), Adam et al (2003), Clarida et al (2000) amongst others. In addition, this study uses a long database which is useful for time series analysis. The analysis uses a modified cointegration and error correction model that is robust to the stationary properties of the data as well as vector autoregression techniques; therefore, our methodology in this study employed three types of econometric tests namely: unit root tests, cointegration tests and error correction models. We used monthly data for the UK over the period October 1992 to December 2014, and we estimate Taylor-type policy rules for the UK in order to find answers to these questions.
Our results indicate that the Central Bank of England has not been following the Taylor rule. In other words, the regression results clearly indicated that the Central Bank of England did not follow the Taylor rule in the period 1992-2014. This is because all coefficients of inflation gap and the output gap were statistically insignificant. In addition, we conclude these results link with the New Consensus Macroeconomics, criticism of inflation targeting and endogenous money theory.
The main contribution in this study is an up-to-date analysis, and evidence that Bank of England policy does not work with Taylor rules. In addition, on the methodological level most previous studies reviewed in the literature have measured the interest rate, inflation and the output gap using one dependent variable, to measure the behaviour of the Central Bank of England, to assess whether the Taylor rule is effective or not. However, this study fills this gap by using two measure for interest rate, three measure for inflation and two variables to measure the output gap, using The Hodrick-Prescott (HP) filter and moving averages, to assess whether the Taylor rule is effective or not effective by using more than one dependent variable.