RDP 2017-06: Uncertainty and Monetary Policy in Good and Bad Times 2. Connections with Existing Literature

A recent strand of the literature has dealt with the measurement of uncertainty. Bachmann, Elstner and Sims (2013) use survey data to compute measures of forecast disagreement that proxy time-varying business-level uncertainty for Germany and the United States. Rossi and Sekhposyan (2015, 2017) propose uncertainty indices based on the distribution of real GDP forecast errors. Jurado et al (2015), Ludvigson et al (2015), and Carriero et al (2016) construct measures of uncertainty based on the (un)predictability of several macroeconomic and financial indicators. Baker, Bloom and Davis (2016) develop an index of economic policy uncertainty that reflects the frequency of keywords related to economic concepts, uncertainty, and policy decisions in a set of leading newspapers. Scotti (2016) constructs a proxy for uncertainty based on Bloomberg forecasts that aims to capture agents' uncertainty surrounding current realisations of real economic activity. Our paper focuses on events that are instrumental for the identification of exogenous variations in a financial uncertainty indicator, that is, the VXO.

Our contribution relates to other papers on the relationship between uncertainty and monetary policy. Caggiano, Castelnuovo and Pellegrino (2017) study the effects of uncertainty shocks in normal times and during the zero lower bound period. They find that uncertainty shocks affect real activity more strongly when the bound is binding. With respect to them, we focus on a period during which monetary policy was conventional and investigate the business cycle dependence of the effects of uncertainty shocks on real activity as well as nominal indicators. Hence, our paper is complementary to Caggiano, Castelnuovo and Pellegrino (2017). A related paper is Alessandri and Mumtaz (2014), who investigate the effects of uncertainty shocks in the presence of high/low financial stress. Differently, our conditioning variables are indicators of the business cycle. Moreover, our paper has a focus on the effectiveness of systematic US monetary policy along the business cycle.

A different strand of the literature analyses the effects of monetary policy shocks in recessions and expansions, see, for example, Weise (1999), Mumtaz and Surico (2015), and Tenreyro and Thwaites (2016); or in the presence of high/low uncertainty, as in Aastveit, Natvik and Sola (2013), Eickmeier, Metiu and Prieto (2016), and Pellegrino (2017a, 20017b). Our paper, instead, deals with a set of different questions regarding the impact of uncertainty shocks conditional on a given stance of the business cycle and a given systematic monetary policy conduct. Gnabo and Moccero (2015) find that risks in the inflation outlook and in financial markets are a more powerful driver of monetary policy regime changes in the United States than the level of inflation and the output gap. Our paper complements their study by investigating the ability of systematic monetary policy to stabilise the US macroeconomic environment after an uncertainty shock.

Our findings on the weaker effectiveness of systematic US monetary policy in recessions can be interpreted via a number of theoretical models. In the presence of labour and capital non-convex adjustment costs, Bloom (2009) and Bloom et al (2014) predict a weak impact of changes in factor prices when uncertainty is high due to ‘wait-and-see’ effects. Vavra (2014) and Baley and Blanco (2016) show that higher uncertainty generates higher aggregate price flexibility, which in turn harms the central bank's ability to influence aggregate demand. Berger and Vavra (2015) build up a model featuring microeconomic frictions that lead to a decline in the frequency of households' durable adjustment during recessions. This dampens the response of aggregate durable consumption to macroeconomic shocks, including policy changes. Our findings are also in line with the empirical result put forth by Mumtaz and Surico (2015), who work with a state-dependent IS curve for the United States and estimate a lower interest rate semi-elasticity in recessions.

From a policy standpoint, our results contribute to the discussion on how to respond to uncertainty shocks. Blanchard (2009) proposes to design policies aimed at removing tail risks, channelling funds towards the private sector, and undoing the ‘wait-and-see’ attitudes by creating incentives to spend. Bloom (2014) suggests using more aggressive policies during periods of heightened uncertainty. In the presence of zero nominal rates, Basu and Bundick (2015) find that uncertainty about future shocks may endogenously arise if state-dependent policies, and in particular forward guidance, are not engineered to exit the zero lower bound. Evans et al (2015) and Seneca (2016) argue that it is optimal to delay the lift-off of the policy rate in the presence of uncertainty on future economic conditions. Our evidence on the asymmetric effects of uncertainty shocks and the effectiveness of systematic monetary policy reinforces these calls for state-dependent policy responses.