The Fed, the Bond Market, and Gradualism in Monetary Policy

• Author: ADI SUNDERAM,JEREMY C. STEIN
• Published date: 01 June 2018
• Date: 01 June 2018
• DOI: http://doi.org/10.1111/jofi.12614

THE JOURNAL OF FINANCE •VOL. LXXIII, NO. 3 •JUNE 2018

The Fed, the Bond Market, and Gradualism

in Monetary Policy

JEREMY C. STEIN and ADI SUNDERAM∗

ABSTRACT

We develop a model of monetary policy with two key features: the central bank has

private information about its long-run target rate and is averse to bond market volatil-

ity. In this setting, the central bank gradually impounds changes in its target into

the policy rate. Such gradualism represents an attempt to not spook the bond mar-

ket. However, this effort is partially undone in equilibrium, as markets rationally

react more to a given move when the central bank moves more gradually. This time-

consistency problem means that society would be better off if the central bank cared

less about the bond market.

FED WATCHING IS SERIOUS BUSINESS for bond market investors and for the finan-

cial market press that serves these investors. Speeches and policy statements

by Federal Reserve officials are dissected word by word for clues they might

yield about the future direction of policy. Moreover, the interplay between the

central bank and the market goes in two directions: not only is the market

keenly interested in making inferences about the Fed’s reaction function, the

Fed also takes active steps to learn what market participants think the Fed is

thinking. In particular, before every Federal Open Market Committee (FOMC)

meeting, the Federal Reserve Bank of New York performs a detailed survey

of primary dealers, asking such questions as “Of the possible outcomes below,

provide the percent chance you attach to the timing of the first increase in the

federal funds target rate or range. Also, provide your estimate for the most

likely meeting for the first increase.”1

In this paper, we build a model that aims to capture the main elements

of this two-way interaction between the Fed and the bond market. The two

∗Stein is with Harvard University. Sunderam is with Harvard Business School. This paper

was previously circulated under the title “Gradualism in Monetary Policy: A Time-Consistency

Problem?” We are grateful to Adam Wang-Levine for research assistance and to Ryan Chahrour,

Eduardo Davila, Valentin Haddad, and seminar participants at numerous institutions for their

feedback. Special thanks to Michael Woodford and David Romer for extremely helpful comments

on an earlier draft of the paper.The authors have no conflicts of interest, as identified by the Journal

of Finance’s disclosure policy; however,complete statements of their outside activities are available

at https://scholar.harvard.edu/stein/pages/outside-activities and http://people.hbs.edu/asunderam/

outside_activities.pdf.

1This particular question appeared in the September 2015 survey, among others. All the sur-

veys, along with a tabulation of responses, are available at https://www.newyorkfed.org/markets/

primarydealer_survey_questions.html.

DOI: 10.1111/jofi.12614

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distinguishing features of the model are that (i) the Fed has private information

about its preferred value of the target rate and (ii) the Fed is averse to bond

market volatility. These assumptions yield a number of positive and normative

implications for the term structure of interest rates and the conduct of monetary

policy. For the sake of concreteness, and to highlight the model’s empirical

content, we focus most of our attention on the well-known phenomenon of

gradualism in monetary policy.

As described by Bernanke (2004), gradualism is the idea that “the Federal

Reserve tends to adjust interest rates incrementally, in a series of small or

moderate steps in the same direction.” This behavior can be represented em-

pirically by an inertial Taylor rule, with the current level of the federal funds

rate modeled as a weighted average of a target rate—which itself is a function

of inflation and the output gap as in, for example, Taylor (1993)—and the lagged

value of the funds rate. In this specification, the coefficient on the lagged funds

rate captures the degree of inertia in policy. In recent U.S. samples, estimates

of the degree of inertia are strikingly high, on the order of 0.85 in quarterly

data.2

Several authors have proposed theories of this kind of gradualism on the part

of the central bank. One influential line of thinking, due originally to Brainard

(1967) and refined by Sack (1998), is that moving gradually makes sense when

there is uncertainty about how the economy will respond to a change in the

stance of policy. An alternative rationale, proposed by Woodford (2003), argues

that committing to move gradually gives the central bank more leverage over

long-term rates for a given change in the short rate, a property that is desirable

in the context of his model.

In what follows, we offer a different take on gradualism. In our model, the

observed degree of policy inertia is not optimal from an ex ante perspective,

but rather reflects a time-consistency problem. This time-consistency problem

arises from our two key assumptions. First, we assume the Fed has private

information about its preferred value of the target rate. In other words, the

Fed knows something about its reaction function that the market does not.

Although this assumption is not standard in the literature on monetary policy,

it is necessary to explain the basic observation that financial markets respond

to monetary policy announcements, and that market participants devote con-

siderable time and energy to Fed watching.3Notably, our basic results depend

only on the Fed having a small amount of private information. The majority of

the variation in the Fed’s target can come from changes in publicly observed

variables such as unemployment and inflation. All that we require is that some

variation also reflects innovations to the Fed’s private information.

2Coibion and Gorodnichenko (2012) provide a comprehensive recent empirical treatment; see

also Rudebusch (2002,2006). Campbell, Pflueger, and Viceira (2015) argue that the degree of

inertia in Federal Reserve rate-setting became more pronounced after about 2000.

3Put differently, if the Fed mechanically followed a policy rule that was a function of only

publicly observable variables (e.g., the current values of the inflation rate and the unemployment

rate), then the market would react to news releases about movements in these variables but not

to Fed policy statements.

The Fed and the Bond Market 1017

Second, we assume that the Fed behaves as if it is averse to bond market

volatility. We model this concern in reduced form by simply putting the volatil-

ity of long-term rates into the Fed’s objective function. However, a preference

of this sort can be rooted in an effort to deliver on the Fed’s traditional dual

mandate. For example, a bout of bond market volatility may be undesirable

not in its own right, but rather because it is damaging to the financial system

and hence to real economic activity and employment.

Nevertheless, in a world of private information and discretionary meeting-

by-meeting decision making, an attempt by the Fed to moderate bond market

volatility can be welfare-reducing. The logic is similar to that in signal-jamming

models (Stein (1989), Holmstrom (1999)). Suppose the Fed observes a private

signal that its long-run target for the funds rate has permanently increased by

100 basis points (bps). If it adjusts fully in response to this signal, raising the

funds rate by 100 bps, long-term rates will move by a similar amount. If it is

averse to such a large movement in long-term rates, the Fed will be tempted

to announce a smaller change in the funds rate, trying to fool the market into

thinking that its private signal was less dramatic. Hence, it will underadjust

to its signal, raising the funds rate by perhaps only 25 bps.

However, if bond market investors understand this dynamic, the Fed’sefforts

to reduce volatility will be partially frustrated in equilibrium. The market will

see the 25- basis point increase in the funds rate and understand that it is likely

to be the first in a series of similar moves, so long-term rates will react more

than one-for-one to the change in the short rate. Still, if it acts on a discretionary

basis, the Fed will always try to fool the market. This is because when it decides

how much to adjust the policy rate, it takes as given the market’s conjecture

about the degree of inertia in its rate-setting behavior. As a result, the Fed’s

behavior is inefficient from an ex ante perspective: Because in equilibrium

the market understands the Fed’s incentives, moving gradually has limited

effectiveness in reducing bond market volatility, but causes the policy rate to

be further from its long-run target than it otherwise would be.

This inefficiency reflects a commitment problem. In particular, the Fed can-

not commit to not trying to smooth the private information that it commu-

nicates to the market via its changes in the policy rate.4One institutional

solution to this problem, in the spirit of Rogoff (1985), would be to appoint a

central banker who cares less about bond market volatility than the represen-

tative member of society. More broadly, appointing such a market-insensitive

central banker can be thought of as a metaphor for building an institutional

culture and set of norms inside the central bank such that high-frequency bond

market movements are not given as much weight in policy deliberations.

4The literature on monetary policy has long recognized a different commitment problem, namely

that, under discretion, the central bank will be tempted to create surprise inflation so as to lower

the unemployment rate. See, for example, Kydland and Prescott (1977) and Barro and Gordon

(1983). More recently, Farhi and Tirole (2012) have pointed to the time-consistency problem that

arises from the central bank’s ex post desire to ease monetary policy when the financial sector is

in distress; their focus on the central bank’s concern with financial stability is somewhat closer in

spirit to ours.