Does the Fed act gradually? a VAR analysis

The tendency for changes in the federal funds rate to be implemented gradually has been considered evidence of an interest rate smoothing objective for the Federal Reserve. This paper investigates whether gradual funds rate movements can be explained by the dynamic structure of the economy and the uncertainty that the Fed faces regarding this structure. Using the estimated structural form from a VAR, the analysis first computes the funds rate that is expected in the presence of additive uncertainty. The expected policy can explain persistent directional movements in the funds rate but reacts too aggressively to changes in the non-policy variables. The observed policy instead dampens interest rate changes and moves gradually towards the expected policy. The analysis is then extended to incorporate parameter uncertainty arising from imprecise estimation of the VAR coefficients. Parameter uncertainty biases the funds rate towards the level predicted by the policy rule that the Fed has historically followed. Because the Fed has traditionally smoothed interest rates, the expected policy under parameter uncertainty can account for a considerable portion of the gradual funds rate movements observed.

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