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TIMING AND SIGNALS OF MONETARY REGIME SWITCHING

Published online by Cambridge University Press:  24 August 2020

Daniel Soques
Daniel Soques*
Affiliation:
University of North Carolina Wilmington
*
Address correspondence to: Daniel Soques, Department of Economics and Finance, University of North Carolina Wilmington, 601 South College Rd, Wilmington, NC28403-5945, USA. e-mail: soquesd@uncw.edu. Phone: +(919) 818-5575.
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Abstract

This study investigates if the reaction function of the Federal Reserve switches between two distinct policy rules. Using a time-varying transition probability framework, we also determine if forward-looking macroeconomic or financial covariates signal an impending monetary regime switch. We find that US monetary policy is best described by a Markov-switching model with two regime processes, one of which controls for heteroskedasticity in the shocks to the policy rule. We find that the Fed switches between an aggressive regime with a relatively high weight on inflation and a dovish regime that is less responsive to inflationary pressures. We find that an increase in private forecasters’ expectations of an impending recession signals a switch from the more aggressive policy regime to the less aggressive regime. A recovery in equity returns signals a return back to the more aggressive regime.

Keywords

Monetary PolicyMarkov-SwitchingTime-Varying Transition Probabilities
Type
Articles
Information
Macroeconomic Dynamics , Volume 26 , Issue 4 , June 2022 , pp. 885 - 919
Copyright
© 2020 Cambridge University Press

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Footnotes

Jordan Fonville provided research assistance. The author benefitted from comments from two anonymous referees and conversations with Santiago Barraza, Yoosoon Chang, Adam Check, Taeyoung Doh, Andrew Foerster, Neville Francis, Ming Chien Lo, Michael Owyang, Laura Jackson Young, and seminar participants at the Federal Reserve Bank of Richmond, the 2017 Conference of the Society for Economic Measurement, the 2018 Symposium of the Society of Nonlinear Dynamics and Econometrics, the 2018 IAAE Annual Conference, the 2018 Midwestern Econometrics Group Conference, and the 2019 Annual Meeting of the Financial Management Association. The author is indebted to Athanasios Orphanides for providing data on the real-time output gap.

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