Squeezing the Interest Rate Smoothing Weight with a Hybrid Expectations Model

Successful descriptions of the short-term nominal interest rate inertial behavior have frequently been obtained with small scale macro models in which a Central Banker minimizes a loss function containing an argument labelled as interest rate smoothing. The rationale for this argument is not straightforward; indeed, there has been a lively debate about it among academics. In this paper we perform a positive exercise to evaluate the relationship existing between private rational expectations and the interest rate smoothing argument. Our findings strongly support rational expectations as an element capable to remarkably reduce the importance of the interest rate smoothing weight in replicating the observed path of the federal funds rate. However, we find a predominance of adaptive expectations in shaping the future paths of inflation ad output gap. Our results also suggest that the Fed has followed a ’Strict Inflation Targeting’ strategy under Greenspan’s regime.