Term structure evidence on interest rate smoothing and monetary policy inertia

Estimated Taylor-type policy rules typically find the Fed adjusts the funds rate only 20-30 percent of the way to its desired level each quarter, widely read as deliberate “interest rate smoothing.” Reviewing estimates of both a backward-looking Taylor rule and the forward-looking Clarida-Galí-Gertler variant on 1987-1999 U.S. data, the paper confirms the standard result: partial-adjustment coefficients around 0.7-0.9, fitting the data far better than a version with no lagged rate at all. The paper then tests the interest-rate-smoothing interpretation against an implication it must carry: if the funds rate genuinely adjusts only partially each quarter, a large share of its future path should be predictable from information already available, and rational financial markets should price that predictability into the term structure. Using eurodollar futures rates to construct real-time forecasts, the paper finds an R² of 0.57 for the funds-rate change one quarter ahead, but only 0.11 two quarters ahead and 0.03 three quarters ahead – essentially no forecastable variation beyond about three months, sharply at odds with what a highly inertial policy rule implies. The paper then shows that a policy rule with immediate, full adjustment (no smoothing at all) but a persistent, serially correlated shock term fits the historical funds-rate data just as well as the standard partial-adjustment rule on conventional goodness-of-fit measures, and formal tests cannot reliably distinguish the two specifications within available samples. Because only the serially-correlated-shock version is consistent with the term structure’s near-total unpredictability of the policy rate beyond a quarter, the paper concludes that the large lag coefficients found throughout the policy-rule literature are largely a statistical illusion generated by omitted persistent shocks to policy, not evidence that central banks deliberately smooth interest-rate changes over multiple quarters.

Glenn D. Rudebusch | Macro Paper Warehouse

Term structure evidence on interest rate smoothing and monetary policy inertia