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The Value of Interest Rate Smoothing: How the Private Sector Helps the Federal Reserve, Economic Review, Federal Reserve Bank of Kansas City

By D. Amato and Thomas Laubach

Abstract

Most central banks conduct monetary policy by setting targets for overnight interest rates. During the 1990s, central banks have tended to move these interest rates in small steps without reversing direction quickly, a practice called interest rate smoothing. For example, the majority of Federal Reserve policy moves in the last decade and a half have come in a sequence of 25-basis-point moves, in striking contrast to the early 1980s, when shortterm interest rates fluctuated widely. In light of this historical contrast, it is natural to ask whether interest rate smoothing is a beneficial way to conduct monetary policy. This article argues that interest rate smoothing is beneficial because the private sector is forwardlooking. The private sector bases its decisions on expectations of the future. Thus, a monetary policy move today will be more effective if it is expected Jeffery D. Amato is an economist at the Bank for International Settlements. Thomas Laubach is an economist at the Federal Reserve Bank of Kansas City. Mingwong Hui, a research associate at the bank, helped prepare the article. The views expressed in this article are those of the authors and do not necessarily reflect those of the Bank for International Settlements or the Federal Reserve System. This article is on the bank’s Website at www.kc.frb.org. to persist over time. By smoothing interest rates, the size of changes in interest rates required to reduce fluctuations in the economy can be smaller than would otherwise be necessary. The first section of this article describes interest rate smoothing. The second section presents evidence that the Federal Reserve has smoothed interest rates in the past and reviews a traditional argument that may explain this apparent behavior. The third section offers an alternative explanation for interest rate smoothing—based on the forward-looking behavior of the private sector—and provides evidence on the benefits of smoothing

Year: 1999
OAI identifier: oai:CiteSeerX.psu:10.1.1.198.1701
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