In their paper, Coibion and Gorodnichenko (2011) argue that in the absence of additional significant economic shocks, the monetary policy reversal is likely to be gradual and provide robust evidence that policy inertia is a more likely source of the persistence in interest rates than the persistent shocks hypothesis. The author mostly agrees with their arguments for some reasons.
First, using the Taylor rule as an analytical framework is appropriate for modeling the endogenous response of monetary policymakers to economic fluctuations. Coibion and Gorodnichenko then provide a novelty and account for significant factors that affect the decision-making process by extending the classic Taylor rule to incorporate both the output gap and the output growth rate. They apply formulas that incorporate interest rate smoothing to the Taylor rule. By doing so, they find high levels of interest smoothing, indicating the presence of policy inertia and suggesting that interest rate adjustments occur gradually over time. Moreover, to explore the possibility of persistent shocks contributing to serial correlation, they assume that the errors in the baseline formula, the Taylor rule, are serially correlated. They compare the fitted values of the Taylor rule under both the policy inertia and persistent shocks interpretations and find that the fitted values for the two interpretations are essentially indistinguishable, indicating that the observed serial correlation can be attributed to policy inertia rather than persistent shocks.
Second, from a technical point of view, Coibion and Gorodnichenko (2011) address the issue of serial correlation in the error terms of the estimated Taylor rule which can lead to an overestimation of the degree of policy inertia. Hence, they provide rigorous evidence using various methods back and validate their findings and arguments. For instance, one important finding is the presence of significant policy inertia, characterized by interest rate smoothing and gradual adjustments in response to economic conditions. This evidence suggests that historical policy changes can be accounted for by interest smoothing to a significant extent, reducing the level of serial correlation in the residuals. Additionally, they explore the response of monetary policy to expected output growth, finding that adjusting for the response to expected output growth in the next quarter leads to more accurate estimates of the persistence of monetary policy shocks. These findings contribute to a better understanding of the determinants of interest rate dynamics and provide valuable insights into the behavior of the central bank.
Third, they argue that central bankers are inclined to adjust interest rates gradually and incrementally, moving them closer to their desired levels through a series of steps rather than making immediate changes as suggested by the baseline Taylor rule. This is also reaching close to the policy-making in practice where central banks typically adjust interest rates on a gradual basis. For example, the interest rate set by the central bank of Indonesia in September 2022 was 4.25%. The interest rate then gradually rose to the level of 4.75% in October 2022, 5.25% in November 2022, 5.50% in December 2022, and 5.75% in January to date (as of June 2023). The central bank made these adjustments as a response to global economic conditions and the rise in the U.S. interest rates. Finally, their points have also considered alternative factors, such as financial market variables and real-time forecast revisions, reflecting sound econometric methodology. By examining their impact on interest rate persistence and finding limited significance, the researchers demonstrate the robustness of their analysis and strengthen the case for policy inertia.
Lastly, in the author’s view, the article suggests that monetary policy can be both forward-looking and backward-looking and that the degree of policy inertia can depend on the specific formulation and the degree of interest rate smoothing in the central bank’s reaction function. If the central bank is highly responsive to past deviations of inflation from its target, then it may be slow to adjust its policy rate in response to new information about the economy, and it can be considered backward-looking. Conversely, if the central bank is more responsive to expected future deviations of inflation from its target, then it may be slow to adjust its policy rate in response to changes in the current economic environment, and it can be considered forward-looking.
References
Coibion, O., & Gorodnichenko, Y. (2011). Why are target interest rate changes so persistent?. NBER Working Papers 16707
Gorodnichenko, Y., & Coibion, O. (2011, January 28). How inertial is monetary policy? implications for the Fed’s exit strategy. CEPR. https://cepr.org/voxeu/columns/how-inertial-monetary-policy-implications-feds-exit-strategy
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