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Does the Term Spread play a role in the FED's reaction function? An Empirical Investigation

  • Vázquez Pérez, Jesús

Using US data for the period 1967:5-2002:4, this paper empirically investigates the performance of a Fedٳ reaction function (FRF) that (i) allows for the presence of switching regimes, (ii) considers the long-short term spread in addition to the typical variables, (iii) uses an alternative monthly indicator of general economic activity suggested by Stock and Watson (1999), and (iv) considers interest rate smoothing. The estimation results show the existence of three switching regimes, two characterized by low volatility and the remaining regime by high volatility. Moreover, the scale of the responses of the Federal funds rate to movements in the rate of inflation and the economic activity index depends on the regime. The estimation results also show robust empirical evidence that the importance of the term spread in the FRF has increased over the sample period and the FRF has been more stable during the term of office of Chairman Greenspan than in the pre-Greenspan period.

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File URL: http://hdl.handle.net/10810/6751
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Paper provided by University of the Basque Country - Department of Foundations of Economic Analysis II in its series DFAEII Working Papers with number 2004-02.

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Date of creation: 2004
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Handle: RePEc:ehu:dfaeii:200402
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Order Information: Postal: Dpto. de Fundamentos del Análisis Económico II, = Facultad de CC. Económicas y Empresariales, Universidad del País Vasco, Avda. Lehendakari Aguirre 83, 48015 Bilbao, Spain
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