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Hawkish or Dovish Fed? Estimating a Time-Varying Reaction Function of the Federal Open Market Committee's Median Participant

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Abstract

This paper estimates a time-varying reaction function of the median participant of the Federal Open Market Committee, using a Taylor rule with time-varying coefficients estimated on one- to three-year ahead median forecasts of the federal funds rate, inflation, and the unemployment rate from the Summary of Economic Projections (SEP). We estimate the model with Bayesian methods, incorporating the effective lower bound on the median federal funds rate projections. The results indicate that the monetary policy rule has become significantly more persistent after the pandemic than in the years prior, and it currently reacts strongly to inflation, at more than twice the responsiveness estimated prior to 2020. Our proposed policy rule produces accurate predictions of the median federal funds rate projections in real time for given SEP forecasts of inflation and the unemployment rate, suggesting that the median participant's reaction function is well-represented by our assumed Taylor rule with time-varying coefficients. Our results show that the median participant's reaction function becomes less persistent and less responsive to inflation yet more responsive to the output gap in anticipation of tighter monetary policy conditions. We also find that labor market activity, inflation, and macroeconomic uncertainty correlate significantly with the evolution of the time-varying coefficients of the rule. Finally, we show that in times of a less persistent policy rule or more responsiveness to inflation, markets perceive nominal bonds as better macroeconomic hedges.

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  • Manuel Gonzalez-Astudillo & Rakeen Tanvir, 2023. "Hawkish or Dovish Fed? Estimating a Time-Varying Reaction Function of the Federal Open Market Committee's Median Participant," Finance and Economics Discussion Series 2023-070, Board of Governors of the Federal Reserve System (U.S.).
    • Handle: RePEc:fip:fedgfe:2023-70
    DOI: 10.17016/FEDS.2023.070
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    References listed on IDEAS

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    1. Richard Clarida & Jordi Galí & Mark Gertler, 2000. "Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 115(1), pages 147-180.
    2. Jing Cynthia Wu & Fan Dora Xia, 2016. "Measuring the Macroeconomic Impact of Monetary Policy at the Zero Lower Bound," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 48(2-3), pages 253-291, March.
    3. Commandeur, Jacques J.F. & Koopman, Siem Jan, 2007. "An Introduction to State Space Time Series Analysis," OUP Catalogue, Oxford University Press, number 9780199228874.
    4. Manuel Gonzalez‐Astudillo, 2018. "Identifying the Stance of Monetary Policy at the Zero Lower Bound: A Markov‐Switching Estimation Exploiting Monetary‐Fiscal Policy Interdependence," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 50(1), pages 115-154, February.
    5. Hess T. Chung & Etienne Gagnon & Taisuke Nakata & Matthias Paustian & Bernd Schlusche & James Trevino & Diego Vilán & Wei Zheng, 2019. "Monetary Policy Options at the Effective Lower Bound : Assessing the Federal Reserve's Current Policy Toolkit," Finance and Economics Discussion Series 2019-003, Board of Governors of the Federal Reserve System (U.S.).
    6. Jeffrey R. Campbell & Charles L. Evans & Jonas D.M. Fisher & Alejandro Justiniano, 2012. "Macroeconomic Effects of Federal Reserve Forward Guidance," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 43(1 (Spring), pages 1-80.
    7. Kim, Chang-Jin & Nelson, Charles R., 2006. "Estimation of a forward-looking monetary policy rule: A time-varying parameter model using ex post data," Journal of Monetary Economics, Elsevier, vol. 53(8), pages 1949-1966, November.
    8. J. Durbin, 2002. "A simple and efficient simulation smoother for state space time series analysis," Biometrika, Biometrika Trust, vol. 89(3), pages 603-616, August.
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    Cited by:

    1. Makram El-Shagi, 2024. "Does the Fed Adhere to its Mandate? Estimating the Federal Reserve's Objective Function," CFDS Discussion Paper Series 2024/3, Center for Financial Development and Stability at Henan University, Kaifeng, Henan, China.

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    More about this item

    Keywords

    Summary of Economic Projections; Reaction function; Taylor rule; FOMC communications; Time-varying coefficients; Censored regression;
    All these keywords.

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C34 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Truncated and Censored Models; Switching Regression Models
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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