Andrew Ang

No-Arbitrage Taylor Rules

Coauthor(s): Sen Dong, Monika Piazzesi.

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Abstract:
We estimate Taylor (1993) rules and identify monetary policy shocks using no-arbitrage pricing techniques. Long-term interest rates are risk-adjusted expected values of future short rates and thus provide strong over-identifying restrictions about the policy rule used by the Federal Reserve. The no-arbitrage framework also accommodates backward-looking and forward-looking Taylor rules. We find that inflation and output gap account for over half of the variation of time-varying excess bond returns and most of the movements in the term spread. Taylor rules estimated with no-arbitrage restrictions differ significantly from Taylor rules estimated by OLS, and monetary policy shocks identified with no-arbitrage techniques are less volatile than their OLS counterparts.

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