RDP 2020-01: Credit Spreads, Monetary Policy and the Price Puzzle 7. Conclusion

There is considerably uncertainty about the extent to which monetary policy affects economic activity and inflation. Indeed, previous empirical work has even provided estimates that are at odds with the Bank's view and standard macroeconomic theory about the direction of these effects. In response to an increase in the cash rate, inflation has been found to rise. This if often explained by an anticipatory component of monetary policy. Inflation does not rise in response to an increase in the cash rate, but the Bank raises the cash rate in anticipation of higher inflation.

In this paper, I show that the failure of standard estimates to account for this anticipatory component of policy is driven by an omitted systematic response of the cash rate to money and credit market conditions. When these conditions ease, the Bank raises the cash rate. As easier credit conditions raise economic activity and inflation, the increase in inflation is then falsely attributed to the increase in the cash rate. Controlling for the Bank's forecasts does not remove this bias as these forecasts do not fully capture the inflationary effects of changing credit conditions. Since easier credit market conditions systematically predict inflation to print higher than forecast by the Bank, the price puzzle emerges even after purging cash rate changes of the Bank's own inflation forecasts.

I show that it is therefore crucial to account for the response of monetary policy to credit market conditions when estimating its inflation effects. Furthermore, it is important to account for cash rate changes expected by financial market participants. Purging cash rate changes of the Bank's response to its forecasts and to several money and credit market spreads and of financial markets' expectations of future cash rate changes provides monetary policy shocks that are unanticipated and exogenous to the inflation outlook. Using these shocks, I find the expected effects of monetary policy. An increase in the cash rate lowers inflation and raises the unemployment rate.