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Real-time estimation of trend output and the illusion of interest rate smoothing

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Author Info
Kevin J. Lansing

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Abstract

Empirical estimates of the Federal Reserve's policy rule typically find that the regression coefficient on the lagged federal funds rate is around 0.8 and strongly significant. One economic interpretation of this result is that the Fed intentionally "smoothes" interest rates, i.e., policymakers move gradually over time to bring the current level of the funds rate in line with a desired level that is determined by consideration of recent economic data. This paper develops a small forward-looking macroeconomic model where in each period, the Federal Reserve constructs a current, or "real-time," estimate of trend output by running a regression on past output data. Using the model as a data-generating mechanism, I show that efforts to identify the Fed's policy rule using final data (as opposed to real-time data) can create the illusion of interest rate smoothing behavior when, in fact, none exists. In particular, I show that the lagged federal funds rate can enter spuriously in final-data policy rule regressions because it helps pick up the Fed's serially correlated real-time measurement errors which are not taken into account by the standard estimation procedure. In model simulations, I find that this mis-specification problem can explain as much as one-half of the apparent degree of "inertia" or "partial adjustment" in the U.S. federal funds rate.

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Article provided by Federal Reserve Bank of San Francisco in its journal Economic Review.

Volume (Year): (2002)
Issue (Month): ()
Pages: 17-34
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Handle: RePEc:fip:fedfer:y:2002:p:17-34

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Keywords: Interest rates Monetary policy Federal funds rate

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Gordon, Robert J, 2000. "Does the 'New Economy' Measure up to the Great Inventions of the Past?," CEPR Discussion Papers 2607, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  2. Athanasios Orphanides, 1998. "Monetary policy rules based on real-time data," Finance and Economics Discussion Series 1998-03, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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  3. Perron, Pierre, 1989. "The Great Crash, the Oil Price Shock, and the Unit Root Hypothesis," Econometrica, Econometric Society, vol. 57(6), pages 1361-1401, November. [Downloadable!] (restricted)
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  4. Marianne Baxter & Robert G. King, 1999. "Measuring Business Cycles: Approximate Band-Pass Filters For Economic Time Series," The Review of Economics and Statistics, MIT Press, vol. 81(4), pages 575-593, November. [Downloadable!] (restricted)
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  5. Finn E. Kydland & Edward C. Prescott, 1990. "Business cycles: real facts and a monetary myth," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Spr, pages 3-18. [Downloadable!]
  6. Kevin J. Lansing & Bharat Trehan, 2003. "Forward-looking behavior and optimal discretionary monetary policy," Working Papers in Applied Economic Theory 2001-03, Federal Reserve Bank of San Francisco. [Downloadable!]
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  7. Rudebusch, Glenn D., 2002. "Term structure evidence on interest rate smoothing and monetary policy inertia," Journal of Monetary Economics, Elsevier, vol. 49(6), pages 1161-1187, September. [Downloadable!] (restricted)
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  8. Richard Clarida & Jordi Galí & Mark Gertler, 2000. "Monetary Policy Rules And Macroeconomic Stability: Evidence And Some Theory," The Quarterly Journal of Economics, MIT Press, vol. 115(1), pages 147-180, February. [Downloadable!] (restricted)
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  9. McCallum, Bennett T. & Nelson, Edward, 1999. "Nominal income targeting in an open-economy optimizing model," Journal of Monetary Economics, Elsevier, vol. 43(3), pages 553-578, June. [Downloadable!] (restricted)
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  10. Perez, Stephen J., 2001. "Looking back at forward-looking monetary policy," Journal of Economics and Business, Elsevier, vol. 53(5), pages 509-521. [Downloadable!] (restricted)
  11. McCallum, Bennett T., 1999. "Issues in the design of monetary policy rules," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 23, pages 1483-1530 Elsevier. [Downloadable!] (restricted)
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(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Sharon Kozicki & P.A. Tinsley, 2007. "Perhaps the FOMC Did What It Said It Did: An Alternative Interpretation of the Great Inflation," Working Papers 07-19, Bank of Canada. [Downloadable!]
    Other versions:
  2. P. Siklos & M. Bohl, 2006. "Asset Prices as Indicators of Euro Area Monetary Policy: An Empirical Assessment of Their Role in a Taylor Rule," Working Papers eg0053, Wilfrid Laurier University, Department of Economics, revised 2006. [Downloadable!]
    Other versions:
  3. Sharon Kozicki & P.A. Tinsley, 2002. "Term premia : endogenous constraints on monetary policy," Research Working Paper RWP 02-07, Federal Reserve Bank of Kansas City. [Downloadable!]
  4. Efrem Castelnuovo, 2003. "Taylor Rules and Interest Rate Smoothing in the US and EMU," Macroeconomics 0303002, EconWPA. [Downloadable!]
  5. Glenn D. Rudebusch, 2006. "Monetary Policy Inertia: Fact or Fiction?," International Journal of Central Banking, International Journal of Central Banking, vol. 2(4), December. [Downloadable!]
    Other versions:
  6. Sophocles N. Brissimis & Nicholas S. Magginas, 2006. "Monetary Policy Rules under Heterogeneous Inflation Expectations," Working Papers 35, Bank of Greece. [Downloadable!]
  7. Athanasios Orphanides & John C. Williams, 2003. "Robust monetary policy rules with unknown natural rates," Finance and Economics Discussion Series 2003-11, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
    Other versions:
  8. Alina Carare & Robert Tchaidze, 2005. "The Use and Abuse of Taylor Rules: How Precisely Can We Estimate Them?," IMF Working Papers 05/148, International Monetary Fund. [Downloadable!]
    Other versions:
  9. James Yetman, 2004. "Speed Limit Policies and Interest Rate Smoothing," Economics Bulletin, Economics Bulletin, vol. 5(17), pages 1-6. [Downloadable!]
  10. John Driffill & Zeno Rotondi, 2007. "Inertia in Taylor Rules," Birkbeck Working Papers in Economics and Finance 0720, Birkbeck, School of Economics, Mathematics & Statistics. [Downloadable!]
    Other versions:
  11. Kirdan Lees, 2006. "What do robust policies look like for open economy inflation targeters?," Reserve Bank of New Zealand Discussion Paper Series DP2006/08, Reserve Bank of New Zealand. [Downloadable!]
  12. Troy Davig & Jeffrey R. Gerlach, 2006. "State-Dependent Stock Market Reactions to Monetary Policy," International Journal of Central Banking, International Journal of Central Banking, vol. 2(4), December. [Downloadable!]
  13. Gerberding, Christina & Worms, Andreas & Seitz, Franz, 2004. "How the Bundesbank really conducted monetary policy : An analysis based on real-time data," Discussion Paper Series 1: Economic Studies 2004,25, Deutsche Bundesbank, Research Centre. [Downloadable!]
  14. Leon, Costas, 2006. "The Taylor rule: can it be supported by the data?," MPRA Paper 1650, University Library of Munich, Germany. [Downloadable!]
  15. Gerberding, Christina & Seitz, Franz & Worms, Andreas, 2007. "Money-based interest rate rules: lessons from German data," Discussion Paper Series 1: Economic Studies 2007,06, Deutsche Bundesbank, Research Centre. [Downloadable!]
  16. James B. Bullard & John Duffy, 2004. "Learning and structural change in macroeconomic data," Working Papers 2004-016, Federal Reserve Bank of St. Louis. [Downloadable!]
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