Macroeconomic and Interest Rate Volatility Under Alternative Monetary Operating Procedures

The current financial crisis has led to the emergence of large risk premia in interbank markets and to a widening spread between risky and riskless interest rates. This suggests that it matters what rate a central bank chooses for setting monetary policy. We examine the volatility of macroeconomic variables and of the yield curve if monetary policy is formulated in terms of the central bank's riskless repo rate or in terms of a risky short-term or long-term money market rate. When financial shocks are large, gearing policy to money market rates yields lower macroeconomic volatility. If policy is set under commitment, using a longer-term market rate appears to be the best strategy, while relying on a short-term market rate for formulating policy seems most attractive under discretion.