Abstract: The tendency for changes in the federal funds rate to be implemented
gradually has been considered evidence of an interest-rate smoothing
objective for the Federal Reserve. This paper investigates whether gradual
movements in the federal funds rate can be explained by the dynamic
structure of the economy and the uncertainty that the Fed faces regarding
this structure, without recourse to including an ad-hoc interest rate
smoothing argument in the objective function of the Fed. The analysis
calculates the optimal funds rate policy given the structural form of the
economy estimated in a VAR. In the absence of parameter uncertainty, the
calculated policy responds more aggressively to changes in the economy than
the observed policy, resulting in a substantially higher volatility of the
funds rate than observed. Parameter uncertainty, however, limits the
willingness of the Fed to deviate from the policy rule that has been
previously implemented. Because the Fed has historically smoothed interest
rates, the calculated policy under parameter uncertainty can account for a
considerable portion of the gradualism observed in funds rate movements.
Keywords: Gradualism, interest-rate smoothing, parameter uncertainty
Full paper (325 KB PDF)
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Last update: April 28, 1998
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