FRBSF Economic
Letter
2007-03; January 26, 2007
Monetary Policy Inertia and Recent Fed Actions
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In
the latest episode of monetary tightening in the United
States, the Federal Open Market Committee (FOMC), which
sets U.S. monetary policy, raised the target level
of its key policy interest rate, the federal funds
rate, from 1% in June 2004 to 5-1/4% in June 2006.
This gradual increase was accomplished via a sequence
of 17 consecutive 25-basis-point increases at successive
FOMC meetings. This slow, steady two-year adjustment
of the policy rate can be given two different interpretations.
One of these is that the gradual nature of the policy
adjustment reflected a slow internal response by the
FOMC, which knew where it was going and how fast it
wanted to get there and simply took its time in raising
the funds rate to the desired level. The other interpretation
is that the final level and the speed of adjustment
to that level were not known for sure in advance, so
the gradual nature of the policy rate adjustment importantly
reflected economic developments and data released during
the tightening. Based on the research summarized in
Rudebusch (2006), this Economic Letter describes these
two interpretations and assesses their relative importance
in accounting for recent monetary policy actions.
Internal and external monetary policy inertia
The funds rate often edges up gradually over the
course of a couple of years and then eventually declines
in
a similar fashion. The source of these persistent movements
has been much debated. One school of thought, the partial
adjustment view, asserts that the persistence of the
funds rate reflects an inertia that is intrinsic or
internal to the FOMC. Under this view, the FOMC intentionally
conducts a long, drawn-out adjustment of the policy
rate in response to economic news, so desired changes
in the funds rate are distributed over time. In this
way, the persistence exhibited by the funds rate reflects
deliberate "interest rate smoothing" or "partial
adjustment" or "gradualism" on the part
of the FOMC.
At a short horizon—say, a couple of months—the
existence of such internal policy inertia is indisputable.
Such
short-term partial adjustment involves, for example,
cutting the policy rate by two 25-basis-point moves
in quick succession, rather than reducing the rate
just once by 50 basis points. However, this short-term
partial adjustment occurs within a quarter and is essentially
independent of whether there is internal monetary policy
inertia over the course of several quarters, which
is the key issue under debate. In particular, many
have argued that there is significant partial adjustment
of the funds rate at a horizon of several quarters,
while others have disagreed, and it is this longer-term
quarterly partial adjustment that is the subject of
this Economic Letter.
The existence of quarterly internal inertia appears
to be supported by many estimated monetary policy rules,
which are essentially regressions of the funds rate
on a set of policy determinants. With quarterly data,
these regressions relate the funds rate to a desired
level, which depends on, say, output and inflation,
and to the lagged funds rate, which captures any partial
adjustment toward that desired level. Typically, the
estimated adjustment coefficient on the lagged funds
rate is very large—on the order of .8—which suggests
that if the FOMC knew it wanted to increase the funds
rate by a percentage point, it would only raise it
by 20 basis points after one quarter and by about 60
basis points after one year. Taken at face value then,
the usual policy rule regressions imply a very high
degree of internal inertia from quarter to quarter.
Unfortunately, such evidence for partial adjustment
is unreliable if the policy rule regressions are misspecified
and omit important determinants of FOMC behavior. This
appears to be the case because monetary policy responds
to many more things, for example, financial crises,
other than the simple measures of output and inflation
included in the policy rule regressions. Therefore,
the regression evidence supporting quarterly internal
inertia appears to be specious.
This argument also leads naturally to the alternative
interpretation of the quarterly persistence of the
funds rate, which is that it largely reflects the response
of the FOMC to the slow cyclical fluctuations in the
key driving variables of monetary policy. That is,
the persistence of the funds rate reflects an inertia
that is extrinsic or external to the FOMC. According
to this second interpretation, the slow adjustment
of the funds rate simply reflects the slow accretion
of information relevant to the setting of the policy
rate by policymakers, who then completely adjust the
policy rate fairly promptly—typically within a few
months—when confronted with new information. Under
this view, the appropriate empirical specification
of the monetary policy rule would include the various
persistent external influences on FOMC behavior as
well as a serially correlated shock to represent those
determinants that cannot be easily measured, and there
would be only a minimal role played by any lagged interest
rate partial adjustment.
Important support for this second interpretation
of the gradual adjustment of monetary policy is provided
by a close examination of the ability of multi-period
interest rates to predict future policy moves. In brief,
the greater the amount of internal policy inertia and
delayed adjustment of the policy rate in reaction to
current information, then the greater the amount of
forecastable future variation in the policy rate. That
is, if the funds rate typically is adjusted by just
20% toward its desired target in a given quarter, then
the remaining 80% of the adjustment should be expected
to occur in future quarters. Assuming that financial
markets understand this internal policy inertia, they
should anticipate the future partial adjustments of
the funds rate and incorporate that trajectory into
the pricing of longer-term interest rates. Thus, the
ability of financial markets to predict future interest
rate movements can be a useful metric to gauge the
degree of internal policy inertia. Rudebusch (2006)
describes several analyses using various samples of
data that conclude the evidence from financial market
prediction of future funds rate movements is consistent
with external but not internal policy inertia. As described
next, the two most recent monetary policy adjustments—the
2004-2006 tightening and the preceding 2001-2003 easing—provide
interesting case studies that also illuminate the limited
extent of policy partial adjustment.
Two recent episodes of policy adjustment
Figure 1 helps characterize the ability of financial
markets to predict future monetary policy actions in
two recent episodes of policy adjustment. The solid
line shows the actual funds rate target from 2000 through
2006, while the dashed lines give the expected funds
rate paths at various points in time based on the forward-looking
fed funds futures market. The expected paths of the
funds rate extend out nine months into the future and
are determined on the middle day of each quarter (which
is merely a representative date).
Consider the gradual easing of policy from January
2001 through June 2003. Under the quarterly internal
policy inertia interpretation, this long sequence of
target changes in the same direction would be viewed
as a set of gradual partial adjustments to a low desired
rate. However, although the funds rate gradually fell,
market participants actually anticipated very few of
these declines at a 6- to 9-month horizon, as they
would have if there had been quarterly policy partial
adjustment. Instead, as the dashed lines show, although
the markets had some information about future funds
rate movements over the next couple of months, as expected
under a very short-term internal partial adjustment,
beyond that short horizon, the markets assumed at each
point in time that the Fed had adjusted the funds rate
down to just about where it wanted the funds rate to
remain based on current information available. This
is consistent with external policy inertia, that is,
the long sequence of monetary easings apparently was
the result of a series of fairly prompt responses to
new information about aggregate economic activity that
turned progressively more pessimistic.
The episode of monetary tightening from 2004 through
2006 might seem in Figure 1 to offer more support for
internal policy inertia and predictability in interest
rates. In this later period, there was certainly more
information about future policy adjustments at a short
horizon. This is not surprising, because, as described
in Rudebusch and Williams (2006), during this episode,
the FOMC provided unprecedented signals about future
policy rate changes such as "the Committee believes
that policy accommodation can be removed at a pace
that is likely to be measured." Such verbal signals
of future policy intentions seem to have boosted the
predictability of interest rates, though largely at
short horizons.
During 2004, 2005, and 2006, it is apparent that
many of the expected interest rate paths are remarkably
well aligned with the actual path for the first three
or four months into the future; however, after about
four months, financial markets consistently underestimated
the extent of the future tightening. That is, markets
expected an even more gradual pace for the policy tightening
than actually occurred. This lack of predictability
is not too surprising if FOMC actions depended importantly
on how the economic data unfolded in real time, because
during much of this episode the economic recovery was
not viewed as well established. Therefore, it appears
that the recent tightening episode was an example of
month-by-month internal policy inertia, but the episode
is consistent with the view that policymakers engaged
in only a limited amount of quarterly partial adjustment.
This interpretation accords with the statements of
some FOMC members at the time. As then Federal Reserve
Board Vice Chairman noted (Ferguson, 2004): "I
believe it to be very important that the FOMC not go
on a forced march to some point estimate of the equilibrium
real federal funds rate. In my judgment, we should
remove the current degree of accommodation at a pace
that is importantly determined by incoming data and
a changed outlook."
Conclusion
Does the persistence of the short-term policy interest
rate reflect deliberate "partial adjustment" or "inertia" on
the part of the central bank? As in many other areas
of economics, understanding the source of dynamic adjustment
is a hard problem. However, in contrast to many other
macrodynamic puzzles, interest rates have a rich set
of predictive information available in financial markets
that can help provide answers. One of the key insights
above is that although the short rate is a policy instrument,
it is also a fundamental driver of longer yields, so
multi-period interest rates can sharpen inference about
the monetary policy reaction function. Recent monetary
policy episodes, in particular, point to fairly rapid
central bank reactions to news and information and
little internal policy inertia.
Glenn D. Rudebusch
Senior Vice President and Associate Director of Research
References
Ferguson, R.W., Jr. 2004. "Equilibrium Real
Interest Rate: Theory and Application." Remarks
to the University of Connecticut School of Business
Graduate Learning Center and the SS&C Technologies
Financial Accelerator, Hartford, Connecticut, October
29, 2004.
Rudebusch, Glenn D. 2006. "Monetary Policy Inertia:
Fact or Fiction?" International Journal of
Central Banking 2(4) (December 2006), pp. 85-135.
Rudebusch, Glenn D., and John C. Williams. 2006. "Revealing
the Secrets of the Temple: The Value of Publishing
Central Bank Interest Rate Projections." Manuscript,
forthcoming in Monetary Policy and Asset Prices, ed.
John Campbell.
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. Comments?
Questions? Contact
us via e-mail or write us at:
Research Department
Federal Reserve Bank of San Francisco
P.O. Box 7702
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