UC Berkeley

While the degree of policy inertia in central banks reaction functions is a central ingredient in theoretical and empirical monetary economics, the source of the observed policy inertia in the United States is controversial, with tests of competing hypotheses, such as interest-smoothing and persistent-shocks, being inconclusive. This paper employs real time data; nested specifications with flexible time series structures; narratives; interest rate forecasts of the Fed, financial markets, and professional forecasters; and instrumental variables to discriminate between competing explanations of policy inertia. The evidence strongly favors the interest-smoothing explanation and thus can help resolve a key puzzle in monetary economics. (JEL C53, E43, E47, E52, E58). © 2012 Asian Network for Scientific Information.