The Fed's Preference for Policy Rate Smoothing: Overestimation Due to Misspecification?

Abstract

The federal funds rate is featured by frequent, small changes in the same direction and infrequent reversals. How to replicate the observed smooth behavior of the federal funds rate with a small scale macroeconomic model? This paper compares the descriptive performance of an empirical fully backward looking model with that of an empirical new-Keynesian hybrid framework. It turns out that the Fed’s monetary policy conduct can be very well described with a framework allowing for the presence of a small but positive fraction of forward looking agents in the IS curve. This element remarkably reduces the large interest rate smoothing weight otherwise needed to track the observed macroeconomic series.

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