Double inertia rules improve monetary policy fit
A new Federal Reserve study finds that 'double-inertial' Taylor rules significantly improve the explanation of U.S. monetary policy gradualism. These rules better fit the federal funds rate path by smoothing both the level and pace of policy rate changes.
Two lags, double the fit
A new Federal Reserve study provides a systematic empirical evaluation of 'double-inertial' Taylor rules through 2025, doubling the sample length of previous work.
The research finds strong evidence that these rules significantly improve the explanation of the federal funds rate path.
With an R2 of 0.57, the double-inertial rule explains more than twice the variation in quarterly changes to the federal funds rate compared to the best single-inertial rule.
This finding is robust across alternative data subsets, the use of shadow rate estimates during effective lower bound periods, substitution of an output gap measure for the unemployment gap, and the use of real-time rather than realized data.
The authors argue that because single-inertial rules capture only part of the gradualism evident in the data, their use in estimated New-Keynesian models risks misspecification.
A double-inertial specification offers a sharper benchmark for policy analysis and forecasting.
The evolution of gradualism
Taylor rules, enhanced by a lagged policy rate (single inertia), have long described gradual policy rate movements.
Yet, abrupt changes in the *pace* of rate adjustments are also uncommon.
Double-inertial rules, building on Carlstrom and Fuerst (2014), smooth both the level and the pace of policy rate changes.
This framework better explains the federal funds rate's behavior during periods like the post-2008 effective lower bound and the rapid 2022-2024 hiking cycle.
Theoretical work, such as Woodford (1999), supports interest rate smoothing as optimal, with some models featuring two policy rate lags, consistent with the double-inertial approach.