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Dynamics of the Federal Funds Target Rate: A Nonstationary Discrete Choice Approach

Ling Hu () and Peter Phillips ()

No 1365, Cowles Foundation Discussion Papers from Cowles Foundation for Research in Economics, Yale University

Abstract: We apply a discrete choice approach to model the empirical behavior of the Federal Reserve in changing the federal funds target rate, the benchmark of short term market interest rates in the US. Our methods allow the explanatory variables to be nonstationary as well as stationary. This feature is particularly useful in the present application as many economic fundamentals that are monitored by the Fed and are believed to affect decisions to adjust interest rate targets display some nonstationarity over time. The empirical model is determined using the PIC criterion (Phillips and Ploberger, 1996; Phillips, 1996) as a model selection device. The chosen model successfully predicts the majority of the target rate changes during the time period considered (1985-2001) and helps to explain strings of similar intervention decisions by the Fed. Based on the model-implied optimal interest rate, our findings suggest that there a lag in the Fed's reaction to economic shocks and that the Fed is more conservative in raising interest rates than in lowering rates.

Keywords: Extended arc sine laws; Federal funds target rate; Interest rate; Monetary policy; Nonstationary discrete choice (search for similar items in EconPapers)
JEL-codes: C22 C25 E43 E52 (search for similar items in EconPapers)
Date: 2002-05
Note: CFP 1112.
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Published in Journal of Applied Econometrics (2004), 19(17): 851-867

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