An ordered probit analysis of monetary policy inertia
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Omer Bayar
Abstract
The two leading explanations of the observed persistence in policy interest rate changes are monetary policy inertia and omitted serially correlated shocks. This paper addresses the persistence debate from the perspective of how to properly model policy rates. An ordered probit model is used to account for the discrete nature of interest rate adjustment, an aspect of policy absent in standard models. Ordered probit results show that the impact of inertia on interest rate setting is considerably smaller than indicated by standard models.
Acknowledgments
I am grateful to Bill Neilson, Mohammed Mohsin, Christian Vossler, participants at the Midwest Econometrics Group and Southern Economic Association meetings, and seminar attendees at the University of Tennessee for helpful comments. Any remaining errors are mine.
Appendix
In this section, I present direct estimates of inertia in the ordered probit model. I start with the traditional partial adjustment model from equation (5), except the model is extended with FFRt−2 to allow second-order dynamics in monthly interest rate setting.
The extended policy rule is consistent with previous studies: Woodford (2003b) demonstrates that optimal policy rules in New Keynesian models feature second-order partial adjustment; Coibion and Gorodnichenko (2012) show that recent Fed policy is best described by partial adjustment of second order without a significant role for serially correlated shocks.
With FFRt−1 subtracted from both sides of equation (A1), the rule can be rewritten as follows.
The ordered probit estimates for equation (A2) along with autocorrelation score statistics and associated p-values are reported in the table at the end of the section.
The score statistics are insignificant at 5 percent level, indicating that residual serial correlation is not a major concern.
Regarding individual response parameters, I obtain bπ=1.36 for inflation, which is close to 1.5 originally proposed by Taylor (1993) and satisfies the Taylor-rule property; increases in inflation lead to greater than one-for-one changes in the nominal interest rate, thereby raising the real interest rate. For the output gap, I receive by=0.85, which is somewhat higher than 0.5 from the Taylor rule.
A word of caution is in order at this point. In the ordered probit framework, the assumed standard deviation of model errors determines the size of estimated parameters; estimates can be made arbitrarily large or small via renormalization. That said, in the current setting with the standard deviation of errors set to unity, the model appears to yield estimates for bπ and by that are realistic and in line with the literature on empirical policy rules.
For the parameter of interest, I obtain λ1+λ2=0.7 in monthly estimation. How does the speed of adjustment implied by this figure compare to standard rules? The typical estimate of λ=0.8 in standard quarterly models indicates that the Fed takes about 3.11 quarters, or over 9 months, to close one half of the gap between the desired funds rate and the actual funds rate: half-life=ln(0.5)/ln(0.8)=3.11. By contrast, the ordered probit estimate of λ=0.7 indicates that the Fed carries out the same adjustment in merely 1.94 months. This figure is consistent with the main result of an upward inertia bias in standard rules and a more convincing estimate of the speed with which the central bank responds to macro developments.
Direct estimates of inertia in the ordered probit model
| Coefficients | Parameter estimate | p-value |
|---|---|---|
| bπ | 1.36 | 0.00 |
| by | 0.85 | 0.00 |
| bcc | −4.60 | 0.00 |
| λ(λ1+λ2) | 0.70 | 0.00 |
| Autocorrelation score statistics | ||
| ξ1 | 0.04 | 0.84 |
| ξ2 | 1.70 | 0.19 |
| ξ3 | 3.59 | 0.06 |
| ξ4 | 0.00 | 0.97 |
| ξ5 | 0.17 | 0.68 |
| ξ6 | 3.01 | 0.08 |
Maximum likelihood estimates for policy response parameters in the ordered probit model are reported. Serial correlation scores and corresponding p-values are also presented.
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Articles in the same Issue
- Frontmatter
- Advances
- International specialization and the return to capital
- How the wage-education profile got more convex: evidence from Mexico
- Contributions
- Africa’s missed agricultural revolution: a quantitative study of the policy options
- Structural transformation and productivity in Latin America
- Public debt and growth in the euro area: evidence from parametric and nonparametric Granger causality
- Transition dynamics in the neoclassical growth model: the case of South Korea
- Household saving in Australia
- An ordered probit analysis of monetary policy inertia
- Fiscal shocks, the real exchange rate and the trade balance: some evidence for emerging economies
- Topics
- Remittances and financial institutions: is there a causal linkage?
- Club convergence in Latin America
