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Why are target interest rate changes so persistent?

  • Olivier Coibion

    ()

    (Department of Economics, College of William and Mary)

  • Yuriy Gorodnichenko

    ()

    (Department of Economics, University of California, Berkeley)

We investigate the source of the high persistence in the Federal Funds Rate relative to the predictions of simple Taylor rules. While much of the literature assumes that this reflects interest-smoothing on the part of monetary policy-makers, an alternative explanation is that it represents persistent monetary policy shocks. Applying real-time data of the Federal Reserve’s macroeconomic forecasts, we document that the empirical evidence strongly favors the interestsmoothing explanation. This result obtains in nested specifications with higher order interest smoothing and persistent shocks, a feature missing in previous work. We also show that policy inertia is present in response to economic fluctuations not driven by exogenous monetary policy shocks. Finally, we argue that the predictability of future interest rates by Greenbook forecasts supports the policy inertia interpretation of historical monetary policy actions.

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Paper provided by Department of Economics, College of William and Mary in its series Working Papers with number 106.

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Length: 34 pages
Date of creation: 23 Jan 2011
Date of revision:
Handle: RePEc:cwm:wpaper:106
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