Long-term inflation expectations and the transmission of monetary policy shocks: Evidence from a SVAR analysis

This 2021 Journal of Economic Dynamics & Control paper by Max Diegel and Dieter Nautz asks whether U.S. long-term inflation expectations respond to monetary policy shocks in a way consistent with a “re-anchoring channel,” and how quantitatively important that channel is for how monetary policy shocks pass through to inflation and unemployment. The authors estimate a four-variable Bayesian structural VAR (inflation, unemployment, a policy rate that splices the federal funds rate with the Krippner 2013 shadow rate through the zero lower bound, and the Survey of Professional Forecasters’ median 10-year-ahead CPI inflation expectation) on quarterly U.S. data from 1991Q4 to 2019Q4, with four lags. Rather than leaving the monetary policy shock’s effect on expectations unrestricted only in the impulse-response sign pattern, they identify it with sign and zero restrictions on the structural impact matrix and, crucially, an additional restriction on the systematic component of the policy rule requiring that the central bank raise the policy rate when long-term inflation expectations rise (a restriction the authors show is binding: without it, only 50% of posterior draws would satisfy that sign, so imposing it substantially shrinks the identified set). A separate expectations shock is identified via zero restrictions reflecting that Survey of Professional Forecasters respondents typically report before the current quarter’s CPI and unemployment releases. The main finding is that, in contrast to earlier studies that found essentially no response, a one-standard-deviation contractionary monetary policy shock causes long-term inflation expectations to fall significantly and persistently (though the effect is ultimately transitory), with monetary policy shocks accounting for roughly 16-28% of the forecast-error variance of long-term expectations across horizons out to ten years. A counterfactual analysis that shuts down this re-anchoring channel shows it matters a great deal for the transmission of monetary policy to inflation – the monetary-policy contribution to inflation’s forecast-error variance collapses from about 15% to under 1% on impact (and from roughly 34% to about 13% at long horizons) once the channel is switched off – but “virtually no effect” on the transmission to unemployment, which is governed instead by the conventional interest-rate channel. A further structural-scenario exercise finds that had the Federal Reserve not responded to expectations shocks since its 2012 inflation-target announcement, median inflation would have been about 57 basis points lower and median unemployment about 99 basis points higher on average, suggesting the Fed’s systematic response to below-target long-term expectations has itself helped stabilize both variables.

Dieter Nautz | Macro Paper Warehouse

Long-term inflation expectations and the transmission of monetary policy shocks: Evidence from a SVAR analysis