Interest-rate smoothing and optimal monetary policy: a review of recent empirical evidence

The Federal Reserve and other central banks tend to change short-term interest rates in sequences of small steps in the same direction and reverse the direction of interest rate movements only infrequently. These characteristics, often referred to as interest-rate smoothing, have led to criticism that policy responds too little and too late to macroeconomic developments, suggesting to some observers that the Federal Reserve has an objective of minimizing interest-rate volatility. This paper, however, argues that the observed degree of interest-rate smoothing may well represent optimal behavior on the part of central banks whose only objectives are to stabilize output and inflation. We summarize recent research on three different explanations of interest-rate smoothing: forward-looking behavior by market participants, measurement error associated with key macroeconomic variables, and uncertainty regarding relevant structural parameters.