Dynamics of the Federal Funds Target Rate: A Nonstationary Discrete Choice Approach

36 Pages Posted: 1 Jun 2002

See all articles by Ling Hu

Ling Hu

Yale University - Department of Economics

Peter C. B. Phillips

University of Auckland Business School; Yale University - Cowles Foundation; Singapore Management University - School of Economics

Date Written: May 2002

Abstract

We apply a discrete choice approach to model the empirical behavior of the Federal Reserve in changing the federal funds target rate, the benchmark of short term market interest rates in the US. Our methods allow the explanatory variables to be nonstationary as well as stationary. This feature is particularly useful in the present application as many economic fundamentals that are monitored by the Fed and are believed to affect decisions to adjust interest rate targets display some nonstationarity over time. The empirical model is determined using the PIC criterion (Phillips and Ploberger, 1996; Phillips, 1996) as a model selection device. The chosen model successfully predicts the majority of the target rate changes during the time period considered (1985-2001) and helps to explain strings of similar intervention decisions by the Fed. Based on the model-implied optimal interest rate, our findings suggest that there a lag in the Fed's reaction to economic shocks and that the Fed is more conservative in raising interest rates than in lowering rates.

Keywords: Extended Arc Sine Laws, Federal Funds Target Rate, Interest Rate, Monetary Policy, Nonstationary Discrete Choice

JEL Classification: C22, C25, E43, E52

Suggested Citation

Hu, Ling and Phillips, Peter C. B., Dynamics of the Federal Funds Target Rate: A Nonstationary Discrete Choice Approach (May 2002). Available at SSRN: https://ssrn.com/abstract=311507

Ling Hu

Yale University - Department of Economics ( email )

28 Hillhouse Ave
New Haven, CT 06520-8268
United States

Peter C. B. Phillips (Contact Author)

University of Auckland Business School ( email )

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New Zealand
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Yale University - Cowles Foundation ( email )

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203-432-5429 (Fax)

Singapore Management University - School of Economics

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Singapore