A New Measure of Monetary Shocks: Derivation and Implications

This 2004 American Economic Review paper by Christina D. Romer and David H. Romer constructs a new narrative-based measure of monetary policy shocks designed to be free of both the endogenous response of policy to current economic conditions and the Federal Reserve’s anticipatory response to expected future developments – two contaminations the authors argue bias the federal funds rate as a policy indicator, pushing estimated output effects toward zero and generating a spurious “price puzzle.” Construction proceeds in two steps: first, reading the FOMC’s Record of Policy Actions and internal expected-rate memos for each scheduled meeting from March 1969 through December 1996 to identify the “intended” federal funds rate change at that meeting, excluding intermeeting moves and moves based on incorrect preliminary data; second, regressing these intended changes on the pre-meeting funds rate level and the Fed’s own Greenbook forecasts of output growth, inflation, and unemployment (levels and forecast revisions, one quarter before through two quarters after the meeting), with the residuals – estimated over 263 meetings, R-squared 0.28 – constituting the shock series. Aggregated to monthly frequency and entered with up to 36-48 lags in single-equation regressions for log industrial production and log PPI over January 1970-December 1996 (N=324), a one-percentage-point contractionary shock is estimated to reduce industrial production by a maximum of 4.3 percent after about 22 months (highly significant, t-statistics above 2.5 from month 17 through 27), an effect that becomes imprecisely estimated by month 48 (-1.7 percent, two-standard-error band -6.4 to +3.0); prices are essentially unaffected for roughly the first two years and then fall substantially, reaching -5.9 percent (t=5.5) at month 48, with no statistically significant price puzzle at any horizon – a sharp contrast with regressions using the actual funds rate, which produce a sustained roughly one-percent rise in prices over the same period. A three-variable recursive VAR (industrial production, PPI, cumulated shock) broadly confirms these patterns, with a smaller peak output effect (-2.9 percent) that the authors attribute to the VAR’s shock being transitory rather than the permanent shock assumed in the single-equation exercise. Controlling for world commodity prices changes results only modestly, which the authors read as evidence the measure is not substantially contaminated by responses to supply shocks; correcting for either endogeneity or anticipatory movements alone, by contrast, is shown to produce much smaller effects than correcting for both together. Central caveats: the sample is constrained to end in 1996 by the five-year Greenbook data embargo (excluding the later Greenspan tenure and the entire post-2008 zero-lower-bound period, to which the intended-funds-rate concept does not apply), a positive coefficient on the first lag of the shock in the output regression traces to a single April 1980 outlier that the authors attribute to sampling error, and the authors themselves flag the lag before prices begin to fall as the paper’s “most important uncertainty,” ranging from about six to twenty-two months across specifications.

Christina D. Romer | Macro Paper Warehouse

A New Measure of Monetary Shocks: Derivation and Implications