Academic journal article Economic Review - Federal Reserve Bank of Kansas City

The Value of Interest Rate Smoothing: How the Private Sector Helps the Federal Reserve

Academic journal article Economic Review - Federal Reserve Bank of Kansas City

The Value of Interest Rate Smoothing: How the Private Sector Helps the Federal Reserve

Article excerpt

Most central banks conduct monetary policy by setting targets for overnight interest rates. During the 1990s, central banks have tended to move these interest rates in small steps without reversing direction quickly, a practice called interest rate smoothing. For example, the majority of Federal Reserve policy moves in the last decade and a half have come in a sequence of 25-basis-point moves, in striking contrast to the early 1980s, when shortterm interest rates fluctuated widely. In light of this historical contrast, it is natural to ask whether interest rate smoothing is a beneficial way to conduct monetary policy.

This article argues that interest rate smoothing is beneficial because the private sector is forwardlooking. The private sector bases its decisions on expectations of the future. Thus, a monetary policy move today will be more effective if it is expected to persist over time. By smoothing interest rates, the size of changes in interest rates required to reduce fluctuations in the economy can be smaller than would otherwise be necessary.

The first section of this article describes interest rate smoothing. The second section presents evidence that the Federal Reserve has smoothed interest rates in the past and reviews a traditional argument that may explain this apparent behavior. The third section offers an alternative explanation for interest rate smoothing-based on the forward-looking behavior of the private sector-and provides evidence on the benefits of smoothing.

I. WHAT IS INTEREST RATE SMOOTING?

Central banks can smooth interest rates at various frequencies. For example, three frequencies at which the Federal Reserve arguably has smoothed interest rates are seasonal, event, and day to day. Seasonal smoothing means that the central bank eliminates all calendar patterns in interest rates. Event smoothing means that, when a crisis occurs that puts sudden upward pressure on interest rates, the central bank provides liquidity to the market to avoid large interest rate changes. Day-to-day smoothing means that the average level of the interest rate over the span of a few days is close to the target level desired by the central bank.1 Economists have provided evidence that the Federal Reserve has engaged in each of these three types of smoothing.2

The focus of this article is a fourth type of smoothing - the smoothing of changes in the central bank's target for the short-term interest rate. Smoothing of this kind means that decisions about the target explicitly depend on recent past decisions about the target; that is, target changes are purposely damped. For example, in recent years, the Federal Reserve has typically considered changes in its target for the federal funds rate at regular meetings of the Federal Open Market Committee (FOMC), which occur roughly every six weeks. But it actually changes the target relatively infrequently. From 1994 to 1998, for example, the FOMC changed the target at 12 of 40 meetings. In addition, though, the FOMC has occasionally changed its target for the federal funds rate between regular meetings. Whether target changes occur at or between regular meetings of the FOMC, the changes tend to be damped. The FOMC's intentional smoothing of its federal funds rate target over a sequence of target changes, as opposed to damping changes in the federal funds rate between target changes, is the focus of this article.

There is evidence that the Federal Reserve has engaged in this type of smoothing. To approximate the interval at which the Federal Reserve has made target decisions, this article presents empirical evidence based on U. S. data at monthly and quarterly frequencies. For example, Chart 1 plots monthly values of the federal funds rate from January 1965 to December 1997.3 The chart indicates that some periods are characterized by a smooth federal funds rate path - for example, the period in the third panel (January 1987 to December 1997). …

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