Fed researchers have recently posted to the Fed’s main website a fun study on Double Inertia, Monetary Policy Rules, and Gradualism. As is usually the case with these studies from the Fed staff, much of the analysis (especially the math) is beyond my competence and patience. And I confess to not having even breezed the entire piece. But I did go looking for the main points and found a couple relevant ones.
Their main point relates to the longstanding view that there is inertia in the level of the federal funds rate. If the path of the economy, summarized by inflation and employment deviations from target and normal respectively, were to justify, say, a 100 basis point change in the funds rate, the Fed would deliver that change in stages. Perhaps they would go 25 four times. One way to express this idea is to say that the lagged funds rate should appear in Taylor Rule models designed to describe (rather than prescribe) the actual behavior of the Fed. As I mentioned, this is a well established idea.
What the authors bring newly to the table is the idea that there is persistence also in the rate of change of the funds rate, in which case two lags of the funds rate should be included in a descriptive Taylor Rule. Accordingly, if they go 75 at one meeting, then expect them to go in the same direction at the next meeting and probably by more than 25. Indeed, this persistence in the rate of change is so strong that incorporating it provides more explanatory power than including economic fundamentals themselves (p.13):
In Table 2, the AR(1) and AR(2) benchmarks perform virtually as well as the single- and double-inertial Taylor rules in terms of the one-quarter levels R2 measure. The AR(2) benchmark, in particular, essentially matches the fit of the double-inertial rule and even slightly outperforms the single-inertial rule, achieving an R2 of 0.98 in both the pre-2007 sample and the full sample. Remarkably, this implies that the second autoregressive term is more useful for next-quarter predictions than the inclusion of economic fundamentals, highlighting the quantitative importance of inertia in the rate of change of the policy rate.
The second interesting point relates to why the Fed might behave in this way. The authors emphasize that they are more interested in describing the Fed’s actual behavior than in working up what the Fed should do. But they do cite some academic research suggesting that double inertia in the funds rate might actually be best practice. I mention this in the interest of full disclosure because it is contrary to my own view, which is that inertia arises largely from the Fed believing that there is a credibility cost to directional changes in the path of the funds rate. It would look amateurish, even though it might well be best practice.
We can largely leave that debate for another time, although I would point out that my explanation seems to do a better job capturing abrupt changes of guidance, which do happen. That aside, what is fun about this paper is that it argues the whole thing might be doubly important! Just as in the scene where Austin Power’s is awoken from a deep sleep, once the Fed starts going, they tend to continue.
I doubt you will want to read the paper, but I can tell you that it opens with a couple very cool and telling quotes from former chairs Yellen and Powell. What the authors are describing is clearly a real thing.
