Why are Federal Funds Rates so Smooth?

Abstract

US monetary policy is characterized by a substantial degree of inertia. While in principle this may well be the outcome of an optimizing central bank behaviour, the ability of any derived policy rule to match the data relies on so large weights for interest rate smoothing into policy makers' preferences as to be theoretically flawed. In this paper we investigate whether such a puzzle can be interpreted as resulting from the concern of monetary authorities for potential misspecifications of the macroeconomic dynamics. Accordingly, we use a novel thick modeling approach to incorporate model uncertainty into the identification of central bank's preferences. The robust thick policy rule shows the kind of smoothness observed in the data without resorting to implausible values for the preference parameters.Model uncertainty, interest rate smoothing, Fed policy preferences, robust optimal monetary policy