The Fed and Interest Rates—A High-Frequency Identification

This 2002 American Economic Review Papers and Proceedings essay by John Cochrane and Monika Piazzesi proposes a high-frequency alternative to monthly-VAR identification of monetary policy shocks, built from daily interest-rate movements around actual Federal Open Market Committee target-change dates rather than from orthogonalized VAR residuals. Following Piazzesi (2001), they construct two shock measures that are zero in any month without a target change: a “target shock” (the change in a given yield from two days before to one day after a target change, regressed on the target-rate change itself) and a “Eurodollar shock” (the change in the one-month Eurodollar rate over the same window). Using daily U.S. interest-rate data and monthly nonfarm employment, CPI, and commodity-price data over 1984-2001, they estimate two regressions on actual target-change dates (Table 1): the target-shock regression (Panel A) finds coefficients ranging from 0.52 (t=9.1) at the one-month Eurodollar rate down to just 0.19 — 19 basis points (t=3.5) — at ten years; the separate Eurodollar-shock regression (Panel B) fits much better (R-squared as high as 0.87 at three months) and is the source of the paper’s “startling” headline figures — a 1-percent unexpected target change moving Treasury yields by 60-70 basis points from three months to three years and by 52 basis points even at ten years. This produces a “level” effect on the yield curve — all maturities moving together — in sharp contrast to the “slope” effect (short rates moving, long rates barely responding) found using monthly Christiano-Eichenbaum-Evans (CEE, 1996) VAR shocks. A separate forecasting regression (Table 2, 1984-2001, R-squared 0.64) shows Fed target changes are much better predicted by long-term rates than short rates — the two-year rate (b=0.87, t=6.7) and five-year rate (b=-0.87, t=-3.5) dominate — while an earlier, broader version of that regression that included all yields (R-squared 0.66, before variables with small t-statistics were dropped to reach the final Table 2 specification) found the one-month rate contributing almost nothing (b=-0.06, t=-0.8); this pattern implies the Fed reacts to market-embedded inflation expectations and to the yield-curve slope’s real-activity signal, consistent with (but outperforming) a Taylor rule. Two further findings complicate the identification: employment rises, rather than falls, following a high-frequency contractionary shock (versus a slow decline under CEE shocks), a difference the authors trace to how each measure classifies the 1979-1982 episode; and neither shock measure shows a statistically significant inflation decline, with the target-shock measure instead showing a large but “dubiously significant” price-puzzle-like increase. Dynamically, all interest rates keep rising for two years after a shock under the high-frequency measures — the ten-year rate rises 0.8 percentage points versus only 0.2 for the CEE shock — a pattern the authors call “troubling” because it runs against the standard intuition that tight policy lowers long-run inflation expectations and hence long rates. The paper’s own tentative conclusion is that because the Fed’s actions are so often forecastable responses to market information, “perhaps there are no true shocks,” and results throughout are described as preliminary, based on a small number of genuine surprises, and not resting on formal statistical inference beyond the reported coefficients and standard errors.

Monika Piazzesi | Macro Paper Warehouse

The Fed and Interest Rates—A High-Frequency Identification