Velocity: A Multivariate Time-Series Approach

The Federal Reserve announces targets for the monetary aggregates that are implicitly conditioned on an assumption about future velocity for each of the monetary aggregates. In this paper we present explicit models of velocity for constructing rigorous tests to determine whether the behavior of velocity has changed from what was expected when the targets were chosen. We use time-series methods to develop alternative forecasts of velocity. Multivariate time-series models of velocity that include information about past interest rates produce significantly better out-of-sample forecasts than do univariate methods. Using this multivariate time-series framework, we analyze the Federal Reserve’s decisions to change, miss, and switch targets from 1980:IQ to l984:IIQ. For this period, we find that when the Federal Reserve deviated from its announced target, velocity deviated significantly from its predicted value.