Does the term spread play a role in the fed funds rate reaction function? An empirical investigation

Using US data for the period 1967:5-2002:4 this paper empirically investigates the performance of a Fed funds rate reaction function (from now on, FRF) that (i) allows for the presence of switching regimes; (ii) considers the long–short term spread in addition to the typical variables; and (iii) uses an alternative monthly indicator of general economic activity suggested by Stock and Watson (J Monet Econ 44:293–335, 1999). The estimation results show the existence of three switching regimes, two characterized by low volatility and the third by high volatility. Moreover, the scale of the responses of the Federal funds rate to movements in the rate of inflation and the economic activity index depends on the regime. The estimation results also show robust empirical evidence that the importance of the term spread in the FRF has increased over the sample period and the FRF was more stable during the term of office of Chairman Greenspan than in the pre-Greenspan period.