«The Policy Preferences of the U.S. Federal Reserve Richard Dennis Federal Reserve Bank of San Francisco July 2004 Working Paper 2001-08 ...»
FEDERAL RESERVE BANK OF SAN FRANCISCO
WORKING PAPER SERIES
The Policy Preferences of the U.S. Federal
Federal Reserve Bank of San Francisco
Working Paper 2001-08
The views in this paper are solely the responsibility of the authors and should not be
interpreted as reflecting the views of the Federal Reserve Bank of San Francisco or the Board of Governors of the Federal Reserve System.
The Policy Preferences of the US Federal Reserve∗ Richard Dennis† Economic Research, Federal Reserve Bank of San Francisco, San Francisco.
July 2004 Abstract In this paper we model and explain US macroeconomic outcomes subject to the discipline that monetary policy is set optimally. Exploiting the restrictions that come from optimal policymaking, we estimate the parameters in the Federal Reserve’s policy objective function together with the parameters in its optimization constraints. For the period following Volcker’s appointment as chairman, we estimate the implicit inﬂation target to be around 1.4% and show that policymakers assigned a signiﬁcant weight to interest rate smoothing. We show that the estimated optimal policy provides a good description of US data for the 1980s and 1990s.
Keywords: Policy Preferences, Optimal Monetary Policy, Regime Change.
JEL Classiﬁcation: E52, E58, C32, C61.
∗ I would like to thank Aaron Smith, Norman Swanson, Graeme Wells, Alex Wolman, colleagues at the Federal Reserve Bank of San Francisco, seminar participants at the Reserve Bank of Australia, Queensland University of Technology, and University of California Santa Cruz, two anonymous referees, and the editor for comments. The views expressed in this paper do not necessarily reﬂect those of the Federal Reserve Bank of San Francisco or the Federal Reserve System.
† Address for Correspondence, Economic Research Department, Mail Stop 1130, Federal Reserve Bank of San Francisco, 101 Market St, CA 94105, USA. Email: Richard.Dennis@sf.frb.org.
1 Introduction This paper uses economic outcomes and macroeconomic behavior to estimate the policy objective function and the implicit inﬂation target for the US Federal Reserve.
Under the assumption that the Federal Reserve sets monetary policy optimally, the parameters in the objective function, which indicate how diﬀerent goals are traded-oﬀ in response to shocks, are estimated together with the implicit inﬂation target and the parameters in the optimization constraints.
Ever since Taylor (1993) showed that a simple three parameter rule provided a good description of short-term interest rate movements in the US, it has become common practice to use estimated policy rules to summarize monetary policy behavior (Clarida et al., 2000). One reason why using estimated rules to describe monetary policy behavior is attractive is that estimated rules capture the systematic relationship between interest rates and macroeconomic variables and, as such, they can be viewed as approximations to central bank decision rules. However, while estimated policy rules can usefully summarize ﬂuctuations in interest rates, their main drawback is that they are unable to address questions about the policy formulation process. This drawback is evident in the fact that the feedback coeﬃcients in estimated rules do not have a structural interpretation and that they do not identify key policy parameters, such as the implicit inﬂation target.
Alongside the literature that estimates monetary policy rules there is an extensive literature that analyzes optimal monetary policy.1 While optimal policy rules are attractive because the policymaker’s objective function is explicit, the resulting rules often conﬂict with estimated policy rules because they imply that policymakers should be very aggressive in response to macroeconomic shocks, but these aggressive responses cannot be found in the data. Consequently, when it comes to describing how interest rates move over time, optimal policy rules do not perform well. Of course, the key reason why optimal policies fail to adequately explain interest rate movements is that the policy objective function is invariably parameterized without reference to the data.
Given the strengths and weaknesses of estimated rules and optimal rules it is natAn incomplete list would include Fuhrer and Moore (1995), Levin et al., (1999), Rudebusch and Svensson (1999), papers in the Taylor (1999) volume, and Dennis (2004a).
ural to combine the two approaches to obtain an optimal rule that is also compatible with observed data. In fact, there are many advantages to being able to describe monetary policy behavior at the level of policy objectives and not just at the level of policy rules. One advantage is that it becomes possible to assess whether observed economic outcomes can be reconciled and accounted for within an optimal policy framework. Two further advantages are that it facilitates formal tests of whether the objective function has changed over time and that it allows key parameters, such as the implicit inﬂation target, to be estimated. Furthermore, estimating the objective function reveals what the policy objectives must be if conventionally estimated rules are the outcome of optimal behavior.
This paper assumes that US monetary policy is set optimally and estimates the policy objective function for the Federal Reserve. With the Rudebusch and Svensson (1999) model providing the optimization constraints, we estimate the parameters in the constraints and the parameters in the policy objective function that best conform to the data. Of course, trying to explain US macroeconomic outcomes within the conﬁnes of an optimal policy framework oﬀers a number of challenges. Even if the analysis is limited to after the mid-1960s, one must contend with the run-up in inﬂation that occurred in the 1970s, the disinﬂation in the 1980s, several large oil price shocks, the Kuwait war, and the recessions that occurred in the early 1980s and 1990s. Indeed, a central message that emerges from estimated policy rules is that while the 1980s and 1990s can be characterized in terms of rules that are empirically stable and that satisfy the Taylor principle,2 the 1970s cannot (Clarida et al., 2000).
Instead, when analyzed in the context of standard macro-policy models, policy rules estimated for the 1970s typically produce instability (in backward-looking models) or indeterminacy (in forward-looking models). In eﬀect, these rules explain the rise in inﬂation that occurred during the 1970s either in terms of the economy being on an explosive path, which is incompatible with optimal policymaking, or in terms of sun-spots and self-fulﬁlling expectations.
Because of these diﬃculties, although we present estimates for data prior to the Volcker disinﬂation, simply in order to see how the 1960s and 1970s can be best deThe Taylor principle asserts that in order to stabilize output and inﬂation the short-term nominal interest rate should respond more than one-for-one with expected future inﬂation.
scribed in terms of optimal policymaking, we largely focus on the 1980s and 1990s.
For the period following Volcker’s appointment to Federal Reserve chairman we investigate how — or even whether — the Volcker-Greenspan period can be characterized in terms of optimal policymaking. We ﬁnd that the parameters in the policy objective function that best ﬁt the data diﬀer in important ways from the values usually assumed in studies that analyze optimal monetary policy. In particular, we do not ﬁnd the output gap to be a signiﬁcant variable in the Federal Reserve’s objective function, which suggests that the output gap enters estimated policy rules because of its implications for future inﬂation, rather than because it is a target variable itself.
In addition, we ﬁnd that describing the data in terms of optimal policymaking requires a much larger weight on interest rate smoothing than is commonly entertained, but that this is not a product of serially correlated policy shocks (c.f. Rudebusch, 2002). The results show that the model does a very good job of explaining economic outcomes during the 1980s and 1990s, and that its impulse response functions are consistent with the responses generated from estimated policy rules. We show that the Federal Reserve’s policy objective function changed signiﬁcantly in the early 1980s and compare our policy regime estimates to the estimates in Favero and Rovelli (2003) and Ozlale (2003).
The structure of this paper is as follows. In the following Section we introduce the model that is used to represent the constraints on the Federal Reserve’s optimization problem and present initial estimates of these constraints. The policy objective function that we estimate is introduced and motivated in Section 3. Section 3 also describes how the optimal policy problem is solved and how the model, with the cross-equation restrictions arising from optimal policymaking imposed, is estimated.
Section 4 compares our study to others in the literature. Section 5 discusses the estimation results and compares them to estimated policy rules and to the estimates in other studies. Section 6 presents looks at the pre-Volcker period and contrasts that period to the Volcker-Greenspan period. Section 7 concludes.
2 The Policy Constraints
When central banks optimize they do so subject to constraints dictated by the behavior of other agents in the economy. How well these constraints explain economic behavior is important if useful estimates of the policy preference parameters are to be obtained. In this paper the economy is described using the model developed in Rudebusch and Svensson (1999). We use the Rudebusch-Svensson model in this analysis for several reasons. First, the model is data-consistent, which is important because the model’s structure limits what the Federal Reserve can achieve through its actions. Second, the model embeds neo-classical steady-state properties, which prevents policymakers from permanently trading oﬀ higher output for higher inﬂation.
Third, the model has been previously used to examine optimal (simple) monetary policy rules, which allows us to build on the results in those studies.
Of course, it would be interesting to consider other macroeconomic structures, in particular structures in which private agents are forward-looking. However, forwardlooking models tend not to ﬁt the data as well as the Rudebusch-Svensson model (Estrella and Fuhrer, 2002), and the estimation problem becomes signiﬁcantly more complicated because time-inconsistency issues must be addressed. In this paper we analyze the Rudebusch-Svensson model, paying careful attention to parameter instability. Elsewhere, Dennis (2004b) estimates the policy objective function for the US using an optimization-based New Keynesian sticky-price model in which both households and ﬁrms are forward-looking.
According to the Rudebusch-Svensson model, output gap and inﬂation dynamics are governed by
where Pt is the GDP chain-weighted price index. The error terms gt and vt are interpreted as demand shocks and supply shocks, respectively.
To illustrate the basic characteristics of the model, we estimate equations (1) - (2) using SUR, which allows for the possibility that the demand and supply shocks may be correlated. The sample period considered is 1966.Q1 — 2000.Q2, which covers the oil price shocks in the 1970s, the switch to non-borrowed reserves targeting in late 1979, the Volcker recession in the early 1980s, the oil price ﬂuctuations during the Kuwait war in 1991, and the Asian ﬁnancial crisis of 1997. In terms of Federal Reserve chairmen, the sample includes all or part of the Martin, Burns, Miller, Volcker, and Greenspan regimes. At this stage, equations (1) and (2) are estimated conditional on the federal funds rate; in Section 4 we estimate these constraints jointly with an (optimization-based) equation for the federal funds rate. Baseline estimates of equations (1) and (2) are shown in Table 1.
Dynamic homogeneity in the Phillips curve cannot be rejected at the 5% level (p-value = 0.413) and is imposed, ensuring that the Phillips curve is vertical in the long run. A vertical long-run Phillips curve insulates the steady-state of the real economy from monetary policy decisions and from the implicit inﬂation target, but it also means that the implicit inﬂation target cannot be identiﬁed from the Phillips curve. To estimate the economy’s implicit inﬂation target it is necessary to augment the model with an explicit equation for the federal funds rate, as is done in Section
4. Both lags of the output gap are signiﬁcant in the IS curve. These lagged output gap terms are important if the model is to have the hump-shaped impulse responses typically found in VAR studies (King et al., 1991, Galí, 1992). From the IS curve, the economy’s neutral real interest rate over this period is estimated to be 2.34%.3 The point estimates in Table 1 are similar to those obtained in Rudebusch and Svensson (1999), who estimate the model over 1961.Q1 — 1996.Q2, and broadly similar to those obtained in Ozlale (2003), who estimate it over 1970.Q1 — 1999.Q1.
From equation (1) the neutral real interest rate can be estimated from r∗ = i∗ − π∗ = − a0.
a3 Subsequent analysis focuses on the period following Volcker’s appointment to Federal Reserve chairman, which we term the Volcker-Greenspan period for convenience.