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.

Oil prices rose sharply prior to the onset of the 2007–2009 recession. Hamilton [in the Palgrave Dictionary of Macroeconomics (2008)] noted that nine of the last ten recessions in the United States were preceded by a substantial increases in the price of oil. In this paper, we consider whether oil price shocks significantly increase the probability of recessions in a number of countries. Because business cycle turning points generally are not available for other countries, we estimate the turning points together with oil's effect in a Markov-switching model with time-varying transition probabilities. We find that, for most countries, oil shocks do affect the likelihood of entering a recession. In particular, for a constant, zero-term spread, an average-sized shock to WTI oil prices increases the probability of recession in the United States by nearly 50 percentage points after one year and nearly 90 percentage points after two years.