Interest rate reaction functions and the Taylor rule in the euro area

Traditional Taylor rules, which are estimated using a level specification linking the short-term interest rate to inflation and the output gap, are unstable when estimated on euro area data and forecast poorly out of sample. We present an alternative reaction function which takes the non-stationarity of the data into account. The estimated interest rate rule is stable and forecasts well. In contrast to the traditional Taylor rule, we find a ignificant role for the long rate, which we argue reflects shifts in the publicu0092s perception of the long-run inflation objective.