Why are Target Interest Rate Changes so Persistent?
College of William and Mary
University of California, Berkeley - Department of Economics; National Bureau of Economic Research (NBER); Institute for the Study of Labor (IZA)
January 11, 2011
We investigate the source of the high persistence in the Federal Funds Rate relative to the predictions of simple Taylor rules. While much of the literature assumes that this reflects interest-smoothing on the part of monetary policy-makers, an alternative explanation is that it represents persistent monetary policy shocks. Applying real-time data of the Federal Reserve’s macroeconomic forecasts, we document that the empirical evidence strongly favors the interest-smoothing explanation. This result obtains in nested specifications with higher order interest smoothing and persistent shocks, a feature missing in previous work. We also show that policy inertia is present in response to economic fluctuations not driven by exogenous monetary policy shocks. Finally, we argue that the predictability of future interest rates by Greenbook forecasts supports the policy inertia interpretation of historical monetary policy actions.
Number of Pages in PDF File: 33
Keywords: Taylor rules, interest rate smoothing, monetary policy shocks
JEL Classification: E3, E4, E5working papers series
Date posted: January 12, 2011
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