Measuring Monetary Policy Shocks

What are the effects on the economy when the Fed raises interest rates? This is a key question in empirical research, but is notoriously hard to answer. The reason is that when the Fed raises interest rates, it usually does so in anticipation of a stronger economy or rising inflation. If we look at what happens to inflation or output following an interest rate hike, it is impossible to distinguish the effect of the Fed’s actions from the effects of the changing fundamentals that led the Fed to act in the first place. New research by a graduate student at UCSD may have finally solved this problem.

A common approach that recent researchers have taken has been to focus on what happens to interest rates within a narrow window of time, say 30 minutes to one day, around a monetary policy announcement. If the time window is narrow enough, one can make a strong case that the changes in interest rates within that window were caused by the Fed announcement itself and not by some other news hitting the market at the same time. By looking for the effects of those specific, narrow changes in interest rates on the economy, researchers hope to learn about the effects of the Fed’s actions.

However, as noted by Campbell et al. (2012)Nakamura and Steinsson (2018)Cieslak and Schrimpf (2018), and some of my own work as well, this doesn’t really solve the problem if the Fed has some information about economic fundamentals that the market doesn’t. Any news that inflation or output are headed up, whether the news comes from the Fed or any other source, will be a development that raises interest rates. An announcement by the Fed that it is raising interest rates relative to what the market anticipated may cause market participants to conclude that the economy is stronger than they thought, and this could be the primary reason why interest rates respond to the Fed’s announcement.

Campbell et al. (2012) and Nakamura and Steinsson (2018) documented an interesting observation that supports that interpretation. Suppose we take the change in the 3-month-ahead fed funds futures contract on the day of an FOMC announcement, and regress the change in the Blue Chip forecast of inflation that month on that one day’s change in the futures price. The coefficient turns out to be positive– when the Fed surprises the market by raising rates, private analysts revise their forecasts to conclude that inflation is headed higher. That doesn’t mean that when the Fed raises rates, it actually causes inflation to go up (rather than the Fed’s intended effect of bringing inflation down). Instead it suggests that the change in futures prices on that day is mostly reflecting changes in economic fundamentals rather than economic policy. If the Fed signals it is more worried about inflation, private analysts conclude that maybe they should be more worried about inflation as well. Similarly, one finds an unexpected increase in fed funds futures on the day of an FOMC announcement is associated with a decrease in Blue Chip unemployment forecasts. Again, that’s exactly the opposite of the effect expected from a monetary contraction, and is instead exactly the effect predicted if the main thing the Fed is doing is revealing information about economic fundamentals.

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Gary Anderson 11 months ago Contributor's comment

Fascinating conclusion. Rate hikes kill stocks. Powell paused and stocks got killed anyway, probably from hikes already in place. Coddling the stock bubble is a worse option than helicopter money to the masses, but nobody has accused the Fed of rational thinking. The stock bubble must, somehow, be a reflection of banking strength.