Photo by Ibrahim Boran on Unsplash

In a recent Mercatus working paper, I argued that monetary policy works in two dimensions, by changing levels of key macro variables and by changing expected future growth rates of those variables.

This is easiest to see when looking at the impact of monetary policy announcements on the spot and forward exchange rate. A monetary policy announcement might cause the spot exchange rate to depreciate while also reducing the expected future appreciation in the currency. Or, it might cause the spot exchange rate to depreciate while raising the expected future appreciation in the currency. There are different kinds of “easy money” policies, and the actual outcome depends in part on “forward guidance”.

After writing this paper, I came across an interesting 2005 paper by Refet S. Gürkaynak, Brian Sack, and Eric T. Swanson. Here is the abstract:

We investigate the effects of U.S. monetary policy on asset prices using a high-frequency event-study analysis. We
test whether these effects are adequately captured by a single factor—changes in the federal funds rate target—and find that they are not. Instead, we find that two factors are required. These factors have a structural interpretation as a “current federal funds rate target” factor and a “future path of policy” factor, with the latter closely associated with Federal Open Market Committee statements. We measure the effects of these two factors on bond yields and stock prices using a new intraday data set going back to 1990. According to our estimates, both monetary policy actions and statements have important but differing effects on asset prices, with statements having a much greater impact on longer-term Treasury yields.

I like the way they look at policy shocks in two dimensions—immediate effects and changes in the expected future path of policy. It’s interesting that the impact on the future expected path of policy comes mostly from the policy statements that accompany the interest rate announcement.

Of course, signals are only effective to the extent that they credibly describe future concrete actions by the central bank:

We emphasize that our findings do not imply that FOMC statements represent an independent policy tool. In particular, FOMC statements likely exert their effects on financial markets through their influence on financial market expectations of future policy actions. Viewed in this light, our results do not indicate that policy actions are secondary so much as that their influence comes earlier—when investors build in expectations of those actions in response to FOMC statements (and perhaps other events, such as speeches and testimony by FOMC members).

This is what I’ve been calling “long and variable leads”.

They also suggest that the findings support claims that monetary policy is still quite effective at the zero bound:

This finding has important implications for the conduct of monetary policy in a low-inflation environment—in particular, even when faced with a low or zero nominal funds rate, our results directly support the theoretical analysis of Reifschneider and Williams (2000) and Eggertsson and Woodford (2003) that the FOMC is largely unhindered in its ability to conduct policy, because it has the ability to manipulate financial market expectations of future policy actions and thereby longer-term interest rates and the economy more generally