Applied asset prices and currency strength in backward- and forward-looking Taylor models

Abstract: The purpose of the thesis is to examine if the Swedish Central Bank, the Riksbank, reacts to changes in asset prices and the strength of the currency when regulating the short term interest rate. The application of backward- and forward-looking Taylor rules will help us evaluate the outcome of the Riksbank’s inflation forecast. The thesis is based on the Taylor rule, augmented with the deviation of asset prices from its trend and the deviation of the TCW-index from its average, to examine if the variables are taken into consideration by the Riksbank. The models were regressed with OLS and TSLS, and the models differentiated by using current inflation against realized inflation one year ahead. The results showed that none of the asset prices or currency strength was found significant, implying that the Riksbank does not react to changes in the augmented variables. The inflation- and GDP-gap was significant in all the backward-looking models, though not in any of the forward-looking models. Differences in the current and forecast-based models show that the Riksbank’s inflation forecast is insufficient.