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

  • Kevin J. Lansing

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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  1. Richard Clarida & Jordi Galí & Mark Gertler, 1997. "Monetary policy rules and macroeconomic stability: Evidence and some theory," Economics Working Papers 350, Department of Economics and Business, Universitat Pompeu Fabra, revised May 1999.
  2. 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.
  3. Glenn D. Rudebusch, 2001. "Term structure evidence on interest rate smoothing and monetary policy inertia," Working Paper Series 2001-02, Federal Reserve Bank of San Francisco.
  4. 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.).
  5. Perron, P, 1988. "The Great Crash, The Oil Price Shock And The Unit Root Hypothesis," Papers 338, Princeton, Department of Economics - Econometric Research Program.
  6. Bennett T. McCallum & Edward Nelson, 2000. "Nominal Income Targeting in an Open-Economy Optimizing Model," NBER Working Papers 6675, National Bureau of Economic Research, Inc.
  7. 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.
  8. John B. Taylor, 1999. "Monetary Policy Rules," NBER Books, National Bureau of Economic Research, Inc, number tayl99-1, January.
  9. Bennett T. McCallum, 1997. "Issues in the Design of Monetary Policy Rules," NBER Working Papers 6016, National Bureau of Economic Research, Inc.
  10. Perez, Stephen J., 2001. "Looking back at forward-looking monetary policy," Journal of Economics and Business, Elsevier, vol. 53(5), pages 509-521.
  11. 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.
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