Are Central Banks Following a Linear or Nonlinear (Augmented) Taylor Rule?

The Taylor rule establishes a simple linear relation between the interest rate, inflation and output gap. However, this relation may not be so simple. To get a deeper understanding of the central banks' behaviour, this paper asks whether central banks are indeed following a linear Taylor rule or, instead, a nonlinear rule. At the same time, it also analyses whether that rule can be augmented with a financial conditions index containing information from some asset prices and financial variables. A forward-looking monetary policy reaction function is employed in the estimation of the linear and nonlinear models. A smooth transition model is used to estimate the nonlinear rule.The results indicate that the European Central Bank and the Bank of England tend to follow a nonlinear Taylor rule, but not the Federal Reserve of the United States. In particular, those two central banks tend to react to inflation only when inflation is above or outside their targets. Moreover, our evidence shows that the European Central Bank is targeting the financial conditions, contrary to the other two central banks. In our judgement, this lack of attention to the financial conditions might be one of the causes of the recent credit crunch that started in the United States