Bank of Italy paper analyses Fed’s ‘gradualist’ policy

There is a stronger transmission mechanism for monetary policy when markets believe a central bank has adopted a “gradualist approach”, argues a working paper published by the Bank of Italy.

In Monetary policy gradualism and the non-linear effects of monetary shocks, Luca Metelli, Filippo Natoli and Luca Rossi look at the US Federal Reserve’s approach monetary policy from 1990 to 2006. This, they say, “has often followed a gradual approach by changing policy rates through multiple small adjustments, rather than all-at-once hikes or cuts”.

The authors identify shocks created by Fed policy in this era. They also attempt to identify when markets believed the Fed was taking a highly “gradualist” approach.

“We find that the responses to US monetary shocks are stronger when the market perception of gradualism is high,” the authors write. “This result comes from the intuition that, by acting gradually, the Fed gives a signal on the intended target rate adjustment, to which investors react.”

This finding, they say, is in line with the conclusion of a 2003 paper by Michael Woodford. As they summarise it, Woodford had predicted that “the perception of gradualism should allow a small adjustment of short rates to generate sizeable long-rate responses”.