DP6570 Inertia in Taylor Rules

Author(s): John Driffill, Zeno Rotondi
Publication Date: November 2007
Keyword(s): expectations hypothesis, Interest Rate Rules, Interest Rate Smoothing, Monetary Policy, Monetary Policy Inertia, Predictability of interest rates, Taylor rule, term structure
JEL(s): E52, E58
Programme Areas: International Macroeconomics
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=6570

The inertia found in econometric estimates of interest rate rules is a continuing puzzle. Many reasons for it have been offered, though unsatisfactorily, and the issue remains open. In the empirical literature on interest rate rules, inertia in setting interest rates is typically modelled by specifying a Taylor rule with the lagged policy rate on the right hand side. We argue that inertia in the policy rule may simply reflect the inertia in the economy itself, since optimal rules typically inherit the inertia present in the model of the economy. Our hypothesis receives some support from US data. Hence we agree with Rudebusch (2002) that monetary inertia is, at least partly, an illusion, but for different reasons.