Monetary policy matters: Evidence from new shocks data

This 2013 Journal of Monetary Economics paper by S. Mahdi Barakchian and Christopher Crowe argues that the standard toolkit for identifying monetary policy shocks – recursive VARs (Christiano-Eichenbaum-Evans), over-identified VARs (Bernanke-Mihov), non-recursive VARs (Sims-Zha), and the Romer-Romer narrative measure – stops delivering plausible results once the sample extends past 1988, because the Federal Reserve’s increasingly forward-looking behavior violates the identifying assumptions these methods rely on: when a VAR omits the forward-looking variables the Fed actually reacts to, its endogenous response to anticipated conditions gets misread as an exogenous shock, biasing the estimated output effect upward. Using each method’s own original specification, the authors show all four produce the “wrong” sign in the post-1988 period – a contractionary shock followed by rising, not falling, output (for example, the CEE recursive VAR shows output declining in 1960Q1-1992Q4 but increasing significantly in 1988Q4-2007Q3, and the Bernanke-Mihov, Sims-Zha, and Romer-Romer methods show the same reversal over their own comparison samples). To sidestep the problem, they construct a new high-frequency-identification (HFI) shock measure from the innovations in six Fed Funds futures contracts (current month through five months ahead) around each of 157 FOMC meetings between 1988:12 and 2008:06, extracting a two-factor structure by maximum likelihood in which the first factor – explaining 92% of the variance, interpreted as a “level” shift in the expected medium-term policy path – is used as the shock, while a second “slope” factor (9% of variance, associated with forward-guidance content) is set aside. Feeding the cumulated new shock into a three-variable monthly VAR (log industrial production, log CPI, and the cumulated shock, with 36 lags and the shock ordered last) over 1988:12-2008:06, industrial production shows a statistically significant, sustained decline after a contractionary shock, with the maximum impact around a two-year horizon – recovering the sign that the conventional methods lose in this period – while prices exhibit a milder price puzzle (turning significantly negative only after about four years) that the authors cannot fully resolve even after adding a commodity price index or survey-based inflation expectations. Forecast error variance decompositions show the new shock accounts for roughly 40-50% of industrial production’s variance at a three-year-plus horizon, around twice the share attributed to existing shock measures over the same period, though the authors note this partly reflects the historically low volatility of the “Great Moderation” sample. A regression of the new shock on the Fed’s exclusive information (Greenbook-Blue Chip forecast gaps for 17 variables, following Romer-Romer, over 113 meetings in 1988-2002) finds no significant joint explanatory power (R-squared = 0.185, F(17) = 1.50, p = 0.132), suggesting the measure is relatively free of the simultaneity bias that could contaminate a directly observed policy-rate innovation – though two individual coefficients (current-quarter output growth and current-quarter GDP deflator) are significant, pointing to some remaining contamination that the authors argue would bias the estimated effects toward zero rather than away from it.

S. Mahdi Barakchian | Macro Paper Warehouse

Monetary policy matters: Evidence from new shocks data