Time-Varying Response of Monetary Policy to Macroeconomic Conditions

Abstract

We reject the hypothesis that the Federal Reserve's response to the macroeconomy over the period of 1953-1994 can be accurately represented with a fixed-parameter discrete choice model. Thus, we model the Fed's time-varying response with a nonlinear Kalman filter. The estimated time paths of the reaction function coefficients suggest that the Fed has responded countercyclically to movements in the price level except for the middle 1970s when it accommodated inflation. The Fed has generally responded countercyclically to unemployment and output during recessions. However, it has not maintained a countercyclical policy during nonrecessionary times until the 1980s. A reaction function empirically relates a monetary policy indicator (often the federal funds rate or a monetary aggregate) to the macroeconomic objectives of monetary policy (usually national output, inflation, and unemployment). Assuming that the underlying macroeconomy is stable, estimated coefficients from a reaction function reveal information about the monetary authority's response to macroeconomic conditions (Chappell, Havrilesky, and McGregor 1993). Beyond the assumption described above, most reaction function studies further assume that the Federal Reserve's response function is linear in the sense that it contains fixed coefficients (see the survey by Barth, Sickles, and Weist 1982, and, more recently, Chappell, Havrilesky, and McGregor 1993); that is, most studies implicitly assume that the Fed responds to a change in inflation, for example, with the same vigor regardless of whether the level of inflation is unusually high or low and regardless of the timing of the response with respect to the business cycle, elections, and so on. Although it is generally recognized that a fixed-coefficient estimate of the Fed's reaction function overly homogenizes the Fed's actual response to macroeconomic conditions, solutions to the problem have been ad hoc. Studies that seek to expose a political business cycle impose structural break-points on the Fed's reaction function based on pre- and postelections periods and then estimate a fixed-coefficient reaction function within each subperiod (Hakes 1988a; Chappell, Havrilesky, and McGregor 1993; Gamber and Hakes 1997). Other studies impose structural break-points based on political or policy regimes and then estimate a fixed-coefficient