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A Model for Policy Interest Rates

Armin Seibert (), Andrei Sirchenko () and Gernot Muller ()
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Armin Seibert: National Research University Higher School of Economics
Gernot Muller: National Research University Higher School of Economics

No WP BRP 192/EC/2018, HSE Working papers from National Research University Higher School of Economics

Abstract: This paper introduces a model that addresses the key worldwide features of modern monetary policy making: the discreteness of policy interest rates both in magnitude and in timing, the preponderance of status quo decisions, policy inertia and regime switching. We capture them by developing a new dynamic discrete-choice model with switching among three latent policy regimes (dovish, neutral and hawkish), estimated via the Gibbs sampler with data augmentation. The simulations and an application to federal funds rate target demonstrate that ignoring these features leads to biased estimates, worse in- and out-of-sample fit, and qualitatively different inference. Using all Federal Open Market Committee?s (FOMC) decisions made both at scheduled and unscheduled meetings as sample observations, we model the Federal Reserve?s response to real-time data available right before each meeting, and control for the endogeneity of monetary policy shocks. The new model, fitted for Greenspan?s tenure, correctly predicts the directions of about 90% of the next decisions on the target rate (hike, no change, or cut) out of sample during Bernanke?s term including the status quo decisions after reaching the zero lower bound, while the conventional linear model fails to adequately tackle the zero bound and wrongly predicts further cuts.

Keywords: Federal funds rate target; FOMC; discrete ordered choice; regime switching; endogeneity; MCMC; Gibbs sampler; data augmentation; autoregressive ordered probit; real-time data (search for similar items in EconPapers)
JEL-codes: C11 C34 C35 E52 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
Date: 2018
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Published in WP BRP Series: Economics / EC, May 2018, pages 1-35

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