Economic Review
Second Quarter 1999

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• How Useful Are Taylor Rules for Monetary Policy?
  By Sharon Kozicki

Over the past several years, Taylor rules have attracted increased attention of analysts, policymakers, and the financial press. Taylor rules recommend a setting for the level of the federal funds rate based on the state of the economy. Taylor rules have become more appealing recently with the apparent breakdown in the relationship between money growth and inflation. But, the usefulness of rule recommendations to policymakers has not been well established.

To be useful to policymakers, rule recommendations should be robust to minor variations in the rule specification. For example, if recommendations differ considerably depending on whether price inflation is measured using the core consumer price index or the chain price index for GDP, then the rule may not be very useful. Rule recommendations should also be reliable. A reliable rule might be expected to replicate federal funds rate settings over a period when policymakers thought policy actions were successful. But, even a rule that can replicate favorable policy actions may not be regarded as reliable if past policy decisions were influenced by economic events beyond the scope of the rule.

Kozicki examines whether recommendations from Taylor rules are useful to policymakers as they decide how to adjust the federal funds rate. She suggests that the usefulness of Taylor rule recommendations to policymakers faced with real-time policy decisions is limited. But Taylor rules may be useful to policymakers in other ways. For example, Taylor rules may provide a good starting point for discussions of issues that concern policymakers. Such rules also play an important role in most forecasting models.

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• How Reliable Are Recession Prediction Models?
  By Andrew J. Filardo

The U.S. economy continues to advance briskly, defying forecasts of more moderate growth. Beginning in March 1991, the current expansion has become the longest peacetime expansion on record and is less than a year away from becoming the longest in U.S. history. To the surprise of some observers, economic growth has been particularly robust late in the expansion. In fact, over the last three years growth has averaged 4 percent annually, and indicators of growth for the first half of 1999 show no signs of significant slowing.

Despite these positive signs, few analysts believe the expansion can go on forever. As the expansion continues to age, economists will increasingly be called on to predict the next recession. Recession prediction models may help them gauge the likelihood of imminent recession.

Filardo examines the reliability of five popular recession prediction models. He concludes that these models have demonstrated some ability in the past to predict recessions. When judiciously interpreted, the models can help resolve uncertainty about the possibility of future recession.

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• Does Faster Loan Growth Lead to Higher Loan Losses?
  By William R. Keeton

During the last couple of years, concern has increased that the exceptionally rapid growth in business loans at commercial banks has been due in large part to excessively easy credit standards. Some analysts argue that competition for loan customers has greatly increased, causing banks to reduce loan rates and ease credit standards to obtain new business. Others argue that as the economic expansion has continued and memories of past loan losses have faded, banks have become more willing to take risks. Whichever explanation is correct, the acceleration in loan growth could lead eventually to a surge in loan losses, reducing bank profits and sparking a new round of bank failures. As the experience of the early 1990s made clear, such a slump in banking could not only threaten the deposit insurance fund but also slow the economy by discouraging banks from granting new loans.

The view that faster loan growth leads to higher loan losses should not be dismissed lightly; nor should it be accepted without question. If loan growth increases because banks become more willing to lend, credit standards should fall and loan losses should eventually rise. But loan growth can increase for reasons other than a shift in supply, for example, businesses may decide to shift their financing from the capital markets to banks, or an increase in productivity may boost the returns to investment. In such cases, faster loan growth need not lead to higher loan losses.

Keeton explains why supply shifts are necessary for faster loan growth to lead to higher loan losses and determines if supply shifts have caused loan growth and loan losses to be positively related in the past. On balance, he finds limited support for the view that supply shifts have caused loan growth and loan losses to be positively related. Data on business loans and delinquencies show that states experiencing unusually rapid loan growth tended to experience unusually big increases in delinquency rates several years later. His finding is tempered, however, by evidence on business loan growth and business credit standards suggesting that changes in loan growth are not always due to shifts in supply.

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• Equity for Rural America: From Wall Street to Main Street -- A Conference Summary
  By Mark Drabenstott and Larry G. Meeker

Equity markets play a crucial role as a lifeline of capital to entrepreneurs. U.S. equity markets are so large and so efficient that they have become an inexpensive way for many companies to raise capital through the issuance of stock. Indeed, many experts argue that the primary benefit of the equity markets is their role in providing new capital for business ventures. But the capital benefits of stock markets do not reach all businesses.

Many rural companies simply lack the size to issue stock directly on Wall Street. In addition, most rural companies cannot boast of the kind of growth prospects that attract venture capitalists. In short, equity capital is a major challenge as rural America searches for ways to help its entrepreneurs and boost economic growth in the new century.

Recognizing that challenge, the Federal Reserve Bank of Kansas City hosted a national conference, "Equity for Rural America: From Wall Street to Main Street." The conference, which was held in Denver on October 8-9, 1998, brought together 125 equity capital market experts, financial market participants, and rural leaders to assess ways to improve rural equity capital markets. Drabenstott and Meeker summarize the proceedings of this important conference for rural America.

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