RDP 2017-02: Anticipatory Monetary Policy and the ‘Price Puzzle’ 6. Implications of Our Results

We experimented with three different approaches – a typical VAR with a recursive identification strategy, the Romer and Romer (2004) approach using RBA forecasts, and a measure of monetary ‘surprises’ – all of which generated a perverse response of inflation to monetary policy. This is surprising. The Romer and Romer approach, in particular, seems at least conceptually to be an obvious strategy for removing the price puzzle, if the cause of the price puzzle is anticipatory monetary policy.

Until we can resolve the price puzzle in a robust way, VAR models will not give us credible estimates of the effect of the Bank's policy instrument – the cash rate – on its key policy objective – the rate of inflation. This is a serious problem, given that VARs have been a leading tool for estimating policy and forecast multipliers.

The existence of a price puzzle also casts serious doubts on the response of output to monetary policy in VAR models. We are concerned that the existence of a price puzzle may be symptomatic of fundamental misspecification. If we have failed to identify the effect of a monetary policy shock on inflation, it is hard to see how we can assume that the same monetary policy shock will yield a reliable estimate for output. This concern is rarely discussed in studies that focus on estimating output responses.