A Dynamic Multivariate Model for Use in Formulating Policy

Tao Zha
Economic Review, Vol. 83, No. 1, 1998

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A policy action by the Federal Reserve consists of using any one of various instruments, such as the federal funds rate and different measures of money, to pursue its multiple objectives. Because of long and variable lags in the effects of policy actions, the process of anticipating the future is indispensable in formulating sound monetary policy. For the same reason, projecting policy effects accurately is a challenging task. An essential step is to develop good forecasting models.

This article presents a forecasting model that seems to overcome conceptual and empirical difficulties encountered in other models and promises to provide policymakers with a more useful tool for anticipating policy effects. For clarity, the author concentrates on changes in the federal funds rate and on only one of the Fed's objectives—low and stable inflation. The model introduces new techniques that offer two distinctive advantages. One is the ability to forecast the values of key macroeconomic variables such as inflation beyond a period over which these values are known. The other is the model's explicit structure that allows empirically coherent ways to assess the uncertainty of forecasts.

March 1998