Which Model to Forecast the Target Rate?

Abstract

Specifications of the Federal Reserve target rate that have more realistic features mitigate in-sample over-fitting and are favored in the data. Imposing a positivity constraint and discrete increments significantly increase the accuracy of model out-of-sample forecasts for the level and volatility of the Federal Reserve target rates. In addition, imposing the constraints produces different estimates of the response coefficients. In particular, a new and simple specification where the target rate is the maximum between zero and the prediction of an ordered-choice Probit model is more accurate and has higher response coefficients to information about inflation and unemployment.

Keywords: Monetary policy, Zero Lower Bound, Non-linear dynamics

JEL Classification: C13, C32, E43, E44, G12