Model Uncertainty, Optimal Monetary Policy and the Preferences of the Fed

Monetary policy in the US is characterized by a substantial degree of inertia. While in principle this may well be the outcome of an optimizing central bank behaviour, the ability of any derived policy rule to match the data relies on so large weights for interest rate smoothing into policy makers' preferences as to be theoretically flawed. In this paper we investigate whether such a puzzle can be interpreted as resulting from the concern of monetary authorities for potential misspecifications of the macroeconomic dynamics. Accordingly, we propose a novel "thick modelling" approach that incorporates model uncertainty into the identification of central bank's preferences. The "thick" robust policy rule shows the kind of smoothness observed in the data without resorting to implausible values for the preference parameters. Copyright (c) Scottish Economic Society 2004.