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Finance and Economics Discussion Series
Finance and Economics Discussion Series logo links to FEDS home page Interpreting the Significance of the Lagged Interest Rate in Estimated Monetary Policy Rules
William B. English, William R. Nelson, and Brian P. Sack

Abstract: Many researchers have found that the lagged interest rate enters estimated monetary policy rules with overwhelming significance. However, a recent paper by Rudebusch (2002) argues that the lagged interest rate is not a fundamental component of the U.S. policy rule, and that its significance arises from the omission of serially correlated variables from the policy rule. This paper demonstrates that, contrary to Rudebusch's claims, these two hypotheses can be directly distinguished in the estimation of the policy rule. Our findings indicate that while serially correlated omitted variables may be present, the lagged interest rate enters the policy rule on its own right and plays an important role in describing the behavior of the federal funds rate.

Keywords: Monetary policy rules, interest rate smoothing

Full paper (138 KB PDF)

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Last update: May 7, 2002