Why is the Fed So Reluctant to React?

In the 2-1/2 years between March, 1996 and September, 1998 the civilian unemployment rate in the United States dropped a full percentage point, the 12-month CPI inflation rate fell nearly 1-1/2 percentage points, a major crisis developed in emerging economies, and commodity prices collapsed. During the same period, the FOMC elected to make just two minor changes in the targeted federal funds rate. This recent experience is by no means unusual. Many researchers have noted a reluctance to react on the part of the Federal Reserve -- and indeed among central banks more generally. Conventional theory suggests that an optimizing monetary authority ought to respond rapidly and frequently to exogenous shocks. How, then, does one reconcile the behavior (and success) of the Fed with what conventional theory suggests? In this paper, we examine four competing hypotheses. The first suggests that the reluctance of the Fed is a reflection of preferences for the stability of the instrument of monetary policy. The second holds that data uncertainty is the answer. The third opines that it is explained by risk sensitivity in the presence of model uncertainty. The fourth is that the Fed chooses to change the federal funds rate as it does in the belief that the anticipation of future fed funds rate changes will "do some of the work" of monetary policy for the Fed. These issues are examined in the context of a small, estimated forward-looking model of the U.S. economy. We find that, while each of these explanations has some bearing on the issue, the fourth possibility is the most promising.