FRBSF Economic Letter
2001-05; March 2, 2001
How Sluggish Is the Fed?
How quickly does the Fed adjust monetary policy in response to developments
in the economy? A common view among economists is that the Fed changes
the short-term policy interest rate at a very sluggish pace over several
quarters. Under this view, if the Fed wanted to increase the policy rate
by a percentage point, it would typically change the rate by only about
25 basis points per quarter for the next few quarters. The evidence supporting
this "monetary policy inertia" view is found in the many monetary
policy rules or reaction functions estimated in the literature with quarterly
data. These estimates appear to imply a very slow speed of adjustment
of the policy rate to its fundamental determinants. For example, Clarida,
Gali, and Gertler (2000, pp. 157-158) describe their empirical estimates
of Fed behavior as "...suggesting considerable interest rate inertia:
only between 10% and 30% of a change in the [desired interest rate] is
reflected in the Funds rate within the quarter of the change." This
conventional wisdom is also adopted in Woodford (1999), Levin, Wieland,
and Williams (1999), Amato and Laubach (1999), Sack and Wieland (2000),
and many other analyses.
This Economic Letter, which summarizes Rudebusch (2001), argues
that this widespread view is mistaken and that the Fed actually responds
quite promptly within the quarter to economic developments. The evidence
against the existence of an inertial policy rule is obtained from the
behavior of short-term market interest rates. There appears to be very
little information generally available in financial markets regarding
future interest rate movements beyond the next one or two months. This
absence of interest rate predictability cannot be reconciled with a significant
degree of interest rate partial adjustment by the Fed; however, an alternative
explanation that stresses the persistence of shocks that the Fed faces
is consistent with the evidence.
Policy inertia and interest rate predictability
Recently, there have been many attempts to estimate policy rules or reaction
functions that explain Fed behavior. These estimation equations take a
general partial adjustment form, where the level of the policy interest
rate in a given quarter is set as a weighted average of the current desired
level and last quarter's actual interest rate. Based on quarterly data,
estimates of this weighted average put about one-fifth of the weight on
the desired rate and about four-fifths on the lagged actual rate. Thus,
these empirical rules appear to imply a very slow speed of adjustment
of the policy rate—about a 20% adjustment each quarter. This gradual
adjustment of the short-term rate over several quarters to its desired
level is widely interpreted as evidence of an "interest rate smoothing"
or "monetary policy inertia" behavior by central banks.
One implication that has been overlooked in the literature is that a
significant amount of policy inertia should imply a lot of predictive
information in financial markets about the future path of short-term interest
rates. Intuitively, if the funds rate is typically adjusted by only 20%
toward its desired target in a given quarter, then the remaining 80% adjustment
should be expected to occur in future quarters. (Rudebusch (2001) shows
that this link between predictable interest rate variation and monetary
inertia ought to hold in a wide variety of settings.)
In a statistical analysis of the data, the sluggish adjustment of interest
rates by the Fed means that a regression of actual changes in interest
rates on predicted changes should yield a good fit (i.e., a moderately
high R2). In fact, many researchers
have estimated such interest rate predictability regressions using postwar
data in order to determine how much information financial markets actually
have about future interest rate movements (see, for example, Mankiw and
Miron 1986 and Rudebusch 1995). These studies typically have found little
predictive information. In particular, beyond a horizon of a few months,
there appears to be very little ability to forecast changes in short-term
interest rates (i.e., a forecast regression R2
close to zero).
Indeed, the literature on interest rate predictability explicitly rejects
any notion of sluggish adjustment by the Fed. Mankiw and Miron (1986,
p. 225) note that the postwar data suggest that at a quarterly frequency
"...while the Fed might change the short rate in response to new
information, it always (rationally) expected to maintain the short rate
at its current level." Goodfriend (1991, p. 10) provides an identical
random-walk characterization of the policy rate and argues that changes
in the rate set by the Fed "...are essentially unpredictable at forecast
horizons longer than a month or two." Similarly, Rudebusch (1995,
p. 264) characterizes the Fed's behavior as, "...beyond a horizon
of about a month, there are no planned movements to react to information
already known."
The illusion of monetary policy inertia
Although many policy rule and reaction function estimates appear to provide
direct empirical evidence of sluggish adjustment by the Fed, the presence
of such quarterly partial adjustment or inertia is contradicted by the
lack of interest rate forecastability in financial markets. Thus, the
apparent monetary policy inertia is an illusion and must be explained
by an alternative interpretation of the Fed's behavior.
As a first step in this explanation, note that there is a large literature
that argues that the partial adjustment model widely used to explain the
Fed's behavior is very difficult to identify and estimate in the presence
of persistent shocks or unobserved omitted variables. In particular, rather
than reflecting some form of partial adjustment, the significant lagged
funds rate in the estimated policy rule may be evidence of persistent
special factors, or shocks, that are not properly accounted for in the
rule. Accordingly, it is hard to tell whether the Fed's adjustment was
sluggish, or whether the Fed generally followed a rule with no policy
inertia but sometimes deviated from this rule for several quarters at
a time.
What would cause such persistent deviations from the rule? Recall the
original analysis of Taylor (1993), which put forward a description of
monetary policy that did not involve partial adjustment. Taylor argued
that recent historical monetary policy had followed a rule only as a guide,
so occasional deviations from the rule were appropriate responses to special
circumstances, not evidence of partial adjustment. This view is illustrated
in Figure 1, which displays the historical
values of the federal funds rate and the fitted values from an estimated
non-inertial Taylor rule, which sets this policy interest rate in response
to the output gap and inflation. The large persistent shocks, the deviations
between the two lines, appear to correspond to several special circumstances
(rather than to sluggish adjustment). Most notably, the deviations in
1992 and 1993 are commonly interpreted as responses to a disruption in
the flow of credit. As Fed Chairman Alan Greenspan testified to Congress
on June 22, 1994:
Households and businesses became much more reluctant to borrow and
spend and lenders to extend credit—a phenomenon often referred to
as the "credit crunch." In an endeavor to defuse these financial
strains, we moved short-term rates lower in a long series of steps
that ended in the late summer of 1992, and we held them at unusually
low levels through the end of 1993—both absolutely and, importantly,
relative to inflation.
Thus, this episode is better described as a persistent "credit crunch"
shock or omitted unobservable variable than as a sluggish partial adjustment
to a known desired rate. In terms of the Taylor rule, the disruption of
credit supply can be treated as a temporary fall in the equilibrium real
rate, which the Fed responds to by lowering the funds rate (relative to
readings on output and inflation). Similarly, a worldwide financial crisis
appeared to play a large role in lowering rates in 1998 and 1999, and
commodity price scares helped push rates up in 1988-1989 and 1994-1995.
Alternatively, Lansing (2000) argues that the Fed may have deviated from
the rule because of persistent errors in the real-time measurement of
the output gap.
While the rule with partial adjustment and the rule with persistent shocks
both appear to fit the data, they have very different economic interpretations.
In the former rule, persistent deviations from an output and inflation
response occur because policymakers are slow to react. In the latter rule,
these deviations reflect the policymaker's response to other influences.
The two types of rules can be distinguished, however, because only the
rule with persistent shocks is consistent with the historical evidence
that short-term interest rates are largely uninformative about the future
course of the policy rate.
Should the Fed be sluggish?
Some researchers also have argued that monetary policy inertia may be
an optimal behavioral response on the part of central banks. For
example, one popular argument contends that policy inertia helps the central
bank focus the public's expectations on its stabilization goals and thereby
achieve a better outcome (e.g., Levin, Wieland, and Williams, 1999, Woodford,
1999, and Sack and Wieland, 2000). However, central bankers tend
to be skeptical of such arguments, especially having been accused of moving
too slowly during the run-up in inflation in the 1970s and having had
some success with a forward-looking "preemptive" policy more
recently. Indeed, the absence of partial adjustment does not mean
that central banks are not trying to influence expectations of future
short-term interest rates as well as long-term interest rates. In
order to influence such rates, central banks only must present a clear
future path for the policy rate. The partial adjustment rule provides
one such path, but it is not the only one. As noted by Goodfriend (1991)
and Rudebusch (1995), the expectation of a constant interest rate path,
which is approximately what the non-inertial rules deliver, is another
obvious choice to communicate policy intentions.
Glenn D. Rudebusch
Senior Research Advisor
References
Amato, Jeffery, and Thomas Laubach. 1999. "The Value of Interest
Rate Smoothing: How the Private Sector Helps the Federal Reserve."
Economic Review, Federal Reserve Bank of Kansas, Third Quarter,
pp. 47-64.
Clarida, Richard, Jordi Gali, and Mark Gertler. 2000. "Monetary
Policy Rules and Macroeconomic Stability: Evidence and Some Theory."
Quarterly Journal of Economics 115, pp. 147-180.
Goodfriend, Marvin. 1991. "Interest Rates and the Conduct of Monetary
Policy." Carnegie-Rochester Series on Public Policy 34, pp.
7-30.
Lansing, Kevin. 2000. "Learning
about a Shift in Trend Output: Implications for Monetary Policy and Inflation."
FRBSF Working Paper 2000-16. <http://www.frbsf.org/econrsrch/workingp/2000/wp00-16bk.pdf>
Levin, Andrew, Volker Wieland, and John C. Williams. 1999. "Robustness
of Simple Monetary Policy Rules under Model Uncertainty." In Monetary
Policy Rules, ed. John B. Taylor, pp. 263-299. Chicago: Chicago University
Press.
Mankiw, N. Gregory, and Jeffrey A. Miron. 1986. "The Changing Behavior
of the Term Structure of Interest Rates." The Quarterly Journal
of Economics 101, pp. 211-228.
Rudebusch, Glenn D. 1995. "Federal Reserve Interest Rate Targeting,
Rational Expectations, and the Term Structure." Journal of Monetary
Economics 35, pp. 245-274.
Rudebusch, Glenn D. 2001. "Term
Structure Evidence on Interest Rate Smoothing and Monetary Policy Inertia."
FRBSF Working Paper 2001-02. <http://www.frbsf.org/publications/economics/papers/2001/wp01-02bk.pdf
>
Sack, Brian, and Volker Wieland. 2000. "Interest Rate Smoothing
and Optimal Monetary Policy: A Review of Recent Empirical Evidence."
Journal of Economics and Business 52, pp. 205-228.
Taylor, John B. 1993. "Discretion versus Policy Rules in Practice."
Carnegie-Rochester Conference Series on Public Policy 39, pp. 195-214.
Woodford, Michael. 1999. "Optimal Monetary Policy Inertia."
The Manchester School Supplement, pp. 1-35.
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
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