RDP 2017-02: Anticipatory Monetary Policy and the ‘Price Puzzle’ 4. What's Going on?

As noted above, we are surprised at the robustness of the price puzzle in Australian data. We are not able to explain this, though several possible arguments are worth noting.

First, one may be tempted to argue that the RBA's forecasts of inflation are uninformative or that the Bank does not respond to these forecasts, and that this explains our findings. However, neither of these claims seems consistent with the evidence. More importantly, they fail to explain the existence of a price puzzle in the first place.

The Romer and Romer (2004) approach would potentially fail if Board members ignore the Bank's official forecasts and instead rely on their own forecasts when setting monetary policy. If the Board's own forecasts were accurate, then policy would be correlated with future inflation in a way we do not control for. However, this possibility seems less likely in Australia than it does in other countries. In other central banks, forecasts and policy are decided by disjoint groups who have separate responsibility for them. In Australia, both forecasts and policy are led by the Governor and Deputy Governor and both are officially the responsibility of the Bank. Moreover, evidence for the United States suggests that FOMC members are unable to improve on staff forecasts (Romer and Romer 2008), which suggests that private information sets of Board members are unlikely to be driving our results.

Another reason why our findings may differ from those of Romer and Romer (2004) is that the latter are sensitive to plausible variations in specification or sample period (Coibion 2012; Barakchian and Crowe 2013). However, this then creates the bigger puzzle of why controlling for anticipatory policy using official forecasts does not reliably work using US data either. If one dismisses the role of anticipatory policy, it is not clear what the alternative explanation for the price puzzle is.

Castelnuovo and Surico (2010) argue that the price puzzle reflects passive monetary policy. They note that increases in inflation in the 1970s were followed by weak monetary policy responses that were insufficient to reverse the inflationary pressure. Hence interest rate increases preceded increases in inflation. This argument may explain why increasing inflation followed interest rate increases. It does not explain why inflation should follow a monetary policy shock, the way it is defined using the Romer and Romer (2004) approach. Persistent or rising inflation, if it is systematic, should be reflected in the central bank forecasts and hence purged from the shock series. It does not seem likely that RBA forecasts systematically failed to detect inflationary pressures on average over the inflation-targeting period. Tulip and Wallace (2012, Section 4.3) report that RBA forecasts of inflation have been more accurate than those of the private sector.

One possibility raised in the literature is the ‘supply’ (or ‘cost’) channel of monetary policy (for an overview, see Castelnuovo (2012)). The idea is that increases in interest rates raise firms' costs (either fixed or marginal, the issues are somewhat different) and hence are passed on in higher prices. We are not aware of evidence that the cost channel is important in Australia, which may reflect that it has not been thoroughly investigated. However, to the extent that it exists, the cost channel might be expected to take longer than the one-quarter lag we estimate in Figures 1 and 2, given that other cost shocks (such as changes in exchange rates or wages) are estimated to flow through to prices with much longer lags.

A more fundamental challenge to the conventional view of monetary policy is the ‘neo-Fisher’ hypothesis of Schmitt-Grohé and Uribe (2014) or Cochrane (2016). They argue that real interest rates are insensitive to monetary policy and hence that an increase in nominal rates will be reflected in a one-for-one increase in inflation. There are several empirical and theoretical objections to the neo-Fisher hypothesis, some of which we note in the introduction. An additional objection is that the neo-Fisher hypothesis would imply a substantial lag from the increase in interest rates to any change in inflation. However, as shown in Figures 1 and 2, the price puzzle emerges the quarter following a change in monetary policy.