RDP 2020-01: Credit Spreads, Monetary Policy and the Price Puzzle 5. The Effects of Monetary Policy Shocks on Inflation, Unemployment and Output

The results from the previous sections suggest that RR shocks used by BT are invalid instruments for truly exogenous monetary shocks for two reasons. First, they violate the exogeneity condition as they capture the Bank's endogenous response to credit market spreads motivated by the predictive information for inflation in those spreads. Second, they are anticipated by financial market participants and hence give rise to the issue of non-fundamentalness in SVAR models.

I will explore the relevance of these two issues in turn. In the first step, I will assess the effects of monetary policy when estimated using the residuals from the Taylor-type policy rule augmented by credit spreads (regression BT-CS of Table 1) as my monetary policy shock series. These ‘first-stage’ residuals are independent of the Bank's response to financial market conditions but are still anticipated to some extent as shown in Section 3.2 (Table 3; Figure 5). In the second step, I will then remove this anticipatory component from these ‘first-stage’ residuals by purging them of the expected cash rate change by financial market participants (Table 3).

At each step, I will estimate the effects of monetary policy on the variables of interest in a simple SVAR with four lags similar to RR, Coibion (2012) and BT. Accordingly, the VAR includes (log) underlying CPI, (log) real GDP, the unemployment rate and a measure of the policy shock, in that order. Here, the policy shock replaces the cash rate typically included to measure the stance of monetary policy. Since the cash rate is typically included in levels, I cumulate the quarterly shock series over time. The ordering imposes the typical recursive identifying assumption that changes in the policy rate do not affect any macroeconomic variables within the same quarter.^[25]

5.1 Accounting for the Cash Rate Response to Credit Conditions

Accounting for the cash rate's response to domestic and international money and credit market spreads has a marked effect on the residuals from Equation (15) – the policy shock series (Figure 6). The residuals from the original BT specification follow actual cash rate changes closely with a correlation of around 0.86, reflecting the low model fit of the regression. In contrast, the correlation between the residuals of the credit spreads-augmented model (BT-CS) with actual policy changes is considerably weaker (0.67).

Most visibly, the response to credit spreads helps to explain the large cash rate changes in the mid 1990s and around the GFC. Whereas the BT specification attributes policy shocks to be the most important source of these changes, the credit spreads-augmented model interprets only around one-fourth of them to be a policy shock independent of the Bank's usual reaction to its forecasts and to credit market conditions. But it is not only large cash rate changes for which the size and direction of the shock differs between the two models. For example, the residual of the augmented model frequently differs in sign from the actual cash rate change and the BT residual, in particular over the tightening cycle prior to the GFC.

These differences in the residual series have strong implications when using them to estimate the effects of monetary policy on the Bank's target variables. Most importantly, there is no evidence for the price puzzle when using the credit spreads-augmented policy shock series (Figure 7, upper right panel). Using the new augmented BT-CS series suggests that prices fall by around 0.15 per cent over six quarters, but the estimated response is subject to considerable uncertainty and not statistically significant.^[26] This is nonetheless in stark contrast to the original BT shock series which suggests that a contractionary policy shock of 100 basis points raises inflation immediately and lifts the price level for a prolonged period of time with a peak effect of around 1 per cent after two years (upper left panel).

In contrast to the response of prices, the estimated effects of monetary policy on the unemployment rate and real GDP are largely unchanged when using the new credit spreads-augmented policy shock series (Figure 7, middle and lower panels). However, some features are worth highlighting. First, using the new credit spreads-augmented BT-CS model residuals as the policy shock, the initially negative unemployment response (the ‘unemployment puzzle’) is now smaller and not statistically significant, and unemployment starts to increase sooner compared to estimates using the original BT residual. These estimates suggests that the unemployment rate peaks around 1/3 of a percentage point higher around six quarters after the shock. The effects on real GDP are also slightly more contractionary with output falling by around 1 per cent over the first year.

5.2 Unanticipated Monetary Policy Shocks

As predicted by the theoretical considerations in Section 2 and the empirical results in Sections 3 and 4, the price puzzle found by Bishop and Tulip (2017) can be explained to a considerable extent by accounting for the systematic response of the cash rate to financial conditions. However, as shown in Section 3.2, the residual of the credit spreads-augmented model (BT-CS) is still anticipated to some extent by financial market participants and hence is not a valid instrument for monetary policy shocks (Ramey 2016; Stock and Watson 2018; Miranda-Agrippino and Ricco 2018). Therefore, I follow Miranda-Agrippino and Ricco (2018) and purge the BT and BT-CS residuals of financial market participants' expectations of the cash rate change ahead of the Board meeting.^[27]

Reflecting the considerable explanatory power of expected cash rate changes for the original BT residuals (Table 3), the purged BT shocks differ considerably from the original shocks (Figure 8, upper panel). This is in line with the previous findings that expectations of cash rate changes – after accounting for the Bank's forecasts – are largely driven by the expected cash rate response to financial market conditions (Table 2). As a result, the unanticipated BT shock series now resembles the BT-CS residuals more closely. In contrast, purging the BT-CS residual of financial market expectations makes little difference, with the exception of the GFC episode (Figure 8, lower panel).

Accordingly, this additional step of removing financial markets' expectations of future cash rate changes from the credit spreads-augmented policy shock series only marginally changes my main results. As before, raising the cash rate lowers inflation and output, and raises the unemployment rate (Figure 9, right panels). However, using this new policy shock series which is both unanticipated and takes into account the Bank's response to credit market conditions suggests slightly stronger contractionary effects of a cash rate change compared with the anticipated BT-CS shock. I now find prices to fall by around 0.7 per cent after around two years before slowly returning to their pre-shock levels. Likewise, the unemployment rate now remains flat for the initial few quarters after the shock before increasing by around 1/3 of a percentage point after six quarters. The output response is largely unchanged.

This is in stark contrast to the original BT shock (Figure 9, left panels). Here, removing financial market expectations from the anticipated shock series makes a strong difference. While removing financial market expectations from the shock removes the price puzzle for the first two years after the shock, inflation nonetheless appears to increase in the long run. Furthermore, the unemployment puzzle is now more pronounced, with unemployment falling by around 1 percentage point over the first two years and only slowly returning to its pre-shock level. This comes on the back of an economic boom with real GDP increasing by around 1 per cent. Overall, the responses of all macroeconomic variables are as implausible as the estimates obtained using the original BT shock.

These results suggest that purging cash rate changes only of the Bank's forecasts and financial market expectations does not yield valid policy shocks, but that it is crucial to explicitly control for the cash rate's systematic response to credit and money market conditions. Once both issues are taken into account, I obtain plausible estimates for the effects of a cash rate change on inflation, the unemployment rate and output. My preferred estimates from the unanticipated, credit spreads-augmented (BT-CS) policy shock are about twice as large for inflation, but otherwise closely in line with the dynamic responses of these variables to a cash rate shock as implied by MARTIN, the Bank's macroeconometric model.

Footnotes

As the policy shocks should already be exogenous to other variables in the VAR, an alternative would be to order the policy shock first and allow all other variables to respond to the shock instantaneously. My results are robust to this and other SVAR specifications, as well as using the local projection (LP) framework by Jordà (2005) to estimate impulse responses (Appendix D). This suggests that the price puzzle does not emerge due to a misspecification of the reduced-form VAR dynamics. [25]

Since the cash rate responds most strongly to domestic money market conditions (Table 1), I find that taking this response into account matters most for resolving the price puzzle. The responses to other financial conditions alone do not resolve the price puzzle; see Figure D4. [26]

Miranda-Agrippino and Ricco go the opposite direction and purge financial market surprises around Fed monetary policy announcement dates of the Fed's Greenbook forecasts. [27]