Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

A Forward-Looking Monetary Policy Reaction Function

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

A Forward-Looking Monetary Policy Reaction Function

Article excerpt

The Federal Reserve's reaction function, which summarizes how the Federal Reserve (Fed) alters monetary policy in response to economic developments, plays an important role in macroeconomic and policy analyses. It can be helpful in predicting actual policy actions, thereby serving as a benchmark for assessing the current stance and the future direction of monetary policy. Also, in macro models, the reaction function is central in evaluating Fed policy and determining effects of other macro policies or economic shocks, implying macroeconomic performance may itself depend upon the conduct of monetary policy. Consequently, there is considerable interest in identifying the nature of actual policy pursued by the Fed and determining whether the estimated reaction function fostered or hindered macroeconomic stability.1

Although numerous monetary policy reaction functions have been estimated, in this article I estimate one that sheds new evidence on the nature of Fed policy since 1979. In particular, I present and estimate a forward-looking monetary policy reaction function that predicts the actual path of the funds rate during most of the period from 1979 to 1997. The distinguishing characteristic of this policy reaction function is that policy responds to movements in longterm inflationary expectations as evidenced by the behavior of the bond rate, an issue discussed first in Goodfriend (1993) but ignored in the recent empirical work on estimated monetary policy rules.2 I also examine whether the policy reaction function has changed significantly during the 1990s, especially during Alan Greenspan's tenure as Fed Chairman. Finally, since this reaction function predicts actual policy actions fairly well, I discuss whether policy during the most recent period 1997Q1 to 1998Q2 is consistent with prior Fed behavior. This period is of interest because during this period the Fed did not adjust the funds rate in response to above-trend real growth.

The policy reaction function that I consider here has both backward- and forward-looking components. It assumes that the funds rate responds to actual inflation, increases in expected future inflation, expected output gap, and the bond rate. The funds rate response to the bond rate captures the influence of long-term inflationary expectations on policy. The empirical work here, which focuses on the behavior of the funds rate over two sample periods, 1960Q2 to 1979Q2 and 1979Q3 to 1998Q2, broadly supports this specification. However, policy responses differ across these sample periods. The most significant difference is that the funds rate has responded to movements in the bond rate after 1979 but not before. This indicates that since 1979 the Fed has been very sensitive to long-term expected inflation; so much so that for most of this period the nominal funds rate has moved more than one-for-one with actual inflation. Hence the real as well as the nominal funds rate increased in response to inflation. That is not the case in the pre-1979 period, when the nominal funds rate did not adjust one-for-one with actual inflation. In that period the real funds rate declined in response to actual inflation.

The policy reaction function given here tracks the actual behavior of the funds rate more closely since 1979 than it does in the period before. The sample period 1979Q3 to 1998Q2 spans the tenures of Paul Volcker and Alan Greenspan as Fed Chairmen. The results, however, indicate that the policy reaction function has not changed much between the Volcker and Greenspan periods. Finally, policy during the most recent subperiod 1997Q1 to 1998Q2 is consistent with prior Fed behavior. While the U.S. economy has grown at a very strong rate during this period, actual inflation has fallen steadily and long-term inflationary expectations as measured by the behavior of the bond rate have remained well behaved. Furthermore, there is also some evidence that the economy's underlying trend growth rate may have increased somewhat during the '90s. …

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