Optimal Monetary Policy Inertia

Abstract

This paper considers the desirability of the observed tendency of central banks to adjust interest rates only gradually in response to changes in economic conditions. It shows, in the context of a simple model of optimizing private-sector behavior, that such inertial policy can be optimal. The reason is that small but persistent changes in short-term interest rates in response to shocks allow a larger effect of monetary policy on long rates and hence upon aggregate demand, for a given degree of overall interest-rate variability. The paper also considers two ways of achieving the desirable degree of inertia in the equilibrium responses to shocks. One is by assignment of a loss function that penalizes squared interest-rate changes (despite the fact that interest-rate changes do not affect the true social objective) to a central bank that is then expected to use discretion in the pursuit of the goal. The second is through commitment to an explicit instrument rule, a generalization of the "Taylor rule" in which the funds rate is an increasing function of the lagged funds rate, as in estimated Fed reaction functions.

Optimal Monetary Policy Under Low Trend Inflation

“…Moreover, it is well-known that optimal monetary policy shows a certain degree of inertia under commitment (see Woodford, 1999). Interestingly, our numerical results clearly illustrate that as trend inflation increases, optimal monetary policy inertia, proxied by the magnitude of the stable eigenvalues, increases.…”

The Fed and short-term rates: Is it open market operations, open mouth operations or interest rate smoothing?

“…Woodford (1999) argues that it is difficult to rationalize interest rate smoothing as an objective in policymakers' loss function. It is sufficient that policymakers are slow to change their target rate in response to a shock, so that they automatically conduct open market operations to resist pressure on the funds rate caused by economic shocks.…”

Forecast-based Monetary Policy

“…Due to the link between interest rate variability and the steady-state level of inÀation H In our previous work, we identi¿ed the historical policy rule with the interest rate equation from a VAR, allowing for contemporaneous feedback from the other endogenous variables. discussed in section 3.1, a commitment to highly persistent interest-rate changes is optimal, as argued by Woodford (1999b).…”