Abstract
Empirical analysis of the Fed’s monetary policy behavior suggests that the Fed smooths interest rates– that is, the Fed moves the federal funds rate target in several small steps instead of one large step with the same magnitude. We evaluate the effect of countercyclical policy by estimating a Vector Autoregression (VAR) with regime switching. Because the size of the policy shock is important in our model, we can evaluate the effect of smoothing the interest rate on the path of macro variables. Our model also allows for variation in transition probabilities across regimes, depending on the level of output growth. Thus, changes in the stance of monetary policy affect the macroeconomic variables in a nonlinear way, both directly and indirectly through the state of the economy. We also incorporate a factor summarizing overall sentiment into the VAR to determine if sentiment changes substantially around turning points and whether they are indeed important to understanding the effects of policy.
Highlights
Empirical analysis of the Fed’s monetary policy behavior suggests that the Fed smooths interest rates– that is, the Fed moves the federal funds rate target in several small steps instead of one large step with the same magnitude
To assess the e¤ects of monetary policy in di¤erent phases of the business cycle, we compute the impulse responses to a shock to the federal funds rate under various model assumptions
Unlike the economic contractions of 2001 and 2007 which elicit a spike in the posterior probability of recession, the 1991 recession does not appear to be associated with a contractionary period that causes a variation in the e¤ects of monetary policy
Summary
Empirical analysis of the Fed’s monetary policy behavior suggests that the Fed smooths interest rates– that is, the Fed moves the federal funds rate target in several small steps instead of one large step with the same magnitude. The models used to measure these responses (e.g., VARs) are often linear and may exaggerate the e¤ectiveness of policy if the dynamics of the economy change across states.[1] Even when the VARs do incorporate some form of regime switching, the responses are often computed within-regime—i.e., the responses are computed assuming that the regime never changes This assumption is problematic for evaluating countercyclical policy. The history of the economy, (3) future shocks, and (4) the size of the (current) monetary shock.[5] We incorporate consumer and producer sentiment into the VAR to determine if con...dence and expectations change substantially around turning points and whether they are important to understanding the e¤ects of policy.
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