How Do Central Banks Set Interest Rates? A Bayesian Model Averaging Analysis

62 Pages Posted: 28 Sep 2021

See all articles by Jonas Gross

Jonas Gross

Frankfurt School of Finance & Management

Tim Kleinlein

University of Bayreuth

Date Written: September 25, 2021

Abstract

This paper analyzes the monetary policy of the Federal Reserve (Fed) and the Bank of England (BoE) both before and after the global financial crisis. In contrast to extant literature, we use a Bayesian model averaging (BMA) approach that does not rely on one underlying empirical model but accounts for model uncertainty around the selection of the empirical model. Accounting for heterogeneity in the monetary policy bodies of these central banks, we estimate approximately 33,000 different empirical models for the Fed and 4,000 for the BoE and derive, in the end, one aggregated reaction function for each central bank. Our results suggest the following: First, both central banks appear to consider more than one model when setting interest rates. Second, while the Fed seems to mainly focus on inflation and, most of the time, economic activity, the BoE seems to focus only on economic activity. Third, applying BMA provides valuable additional explanatory power for the interest rate setting of the Fed by accounting for additional models. However, for the BoE, using a BMA approach does not provide substantial benefits compared to conventional empirical techniques.

Keywords: Taylor rule, Bayesian model averaging, model uncertainty, monetary policy, Federal Reserve, Bank of England

JEL Classification: C11, E43, E58

Suggested Citation

Gross, Jonas and Kleinlein, Tim, How Do Central Banks Set Interest Rates? A Bayesian Model Averaging Analysis (September 25, 2021). Available at SSRN: https://ssrn.com/abstract=3930511 or http://dx.doi.org/10.2139/ssrn.3930511

Jonas Gross (Contact Author)

Frankfurt School of Finance & Management ( email )

Adickesallee 32-34
Frankfurt am Main, 60322
Germany

Tim Kleinlein

University of Bayreuth ( email )

Universitatsstr 30
Bayreuth, D-95447
Germany

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