November/December 2004

In This Edition

  • Discrete Policy Changes and Empirical Models of the Federal Funds Rate

    Empirical models of the federal funds rate almost uniformly use the quarterly or monthly average of the daily rates. One empirical question about the federal funds rate concerns the extent to which monetary policymakers smooth this interest rate. Under the hypothesis of rate smoothing, policymakers set the interest rate this period equal to a weighted average of the rate inherited from the previous quarter and the rate implied by current economic conditions, such as the Taylor rule rate. Perhaps surprisingly, however, little attention has been given to measuring the interest rate inherited from the previous quarter. Previous tests for interest rate smoothing have assumed that the quarterly or monthly average from the previous period is the inherited rate. The authors of this study, in contrast, suggest that the end-of-quarter level of the target federal funds rate is the inherited rate, and empirical tests support this proposition. The authors show that this alternative view of the rate inherited from the past affects empirical results concerning interest rate smoothing, even in relatively rich models that include regime switching.

  • Monetary Policy and Asset Prices: A Look Back at Past U.S. Stock Market Booms

    This article examines the economic environments in which past U.S. stock market booms occurred as a first step toward understanding how asset price booms come about and whether monetary policy should be used to defuse booms. The authors identify several episodes of sustained rapid rises in equity prices in the 19th and 20th centuries, and then assess the growth of real output, productivity, the price level, and money and credit stocks during each episode. Two booms stand out in terms of their length and rate of increase in market prices—the booms of 1923-29 and 1994-2000. In general, the authors find that booms occurred in periods of rapid real growth and productivity advancement, suggesting that booms are driven at least partly by fundamentals. They find no consistent relationship between inflation and stock market booms, though booms have typically occurred when money and credit growth were above average.

  • The Increasing Importance of Proximity for Exports from U.S. States

    Changes in income, trade policies, transportation costs, technology, and many other variables affect the geographic pattern of international trade flows. This paper focuses on the changing geography of merchandise exports from individual U.S. states to foreign countries. Generally speaking, the geographic distribution of state exports has changed so that trade has become more intense with nearby countries relative to distant countries. All states, however, did not experience similar changes. As measured by the distance of trade, which is the average distance that a state's international trade is transported, 40 states experienced a declining distance of trade, while 11 states (including Washington, D.C.) experienced an increasing distance of trade. Evidence, albeit far from definitive, suggests that declining transportation costs over land, the implementation of the North American Free Trade Agreement, and faster income growth by nearby trading partners relative to distant partners have contributed to the changing geography of state exports.

  • What Does the Federal ReserveÂ's Economic Value Model Tell Us About Interest Rate Risk at U.S. Community Banks?

    The savings and loan crisis of the 1980s revealed the vulnerability of some depository institutions to changes in interest rates. Since that episode, U.S. bank supervisors have placed more emphasis on monitoring the interest rate risk of commercial banks. Economists at the Board of Governors of the Federal Reserve System developed a duration-based economic value model (EVM) designed to estimate the interest rate sensitivity of banks. The authors test whether measures derived from the Fed's EVM are correlated with the interest rate sensitivity of U.S. community banks. The answer to this question is important because bank supervisors rely on EVM measures for monitoring and risk-scoping bank-level interest rate sensitivity. The authors find that the Federal Reserve's EVM is indeed correlated with banks' interest rate sensitivity and conclude that supervisors can rely on this tool to help assess a bank's interest rate risk. These results are consistent with prior research that finds the average interest rate risk at banks to be modest, though the potential interaction between interest rate risk and other risk factors is not considered here.

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