Understanding the Price Puzzle

This 1994 Federal Reserve Bank of Dallas Economic Review paper by Nathan S. Balke and Kenneth M. Emery investigates the “price puzzle” – the empirical regularity that a positive innovation to the federal funds rate in a standard reduced-form VAR is followed by a rise, rather than a fall, in prices – using recursive (Cholesky) VARs on quarterly U.S. data spanning 1960:1-1993:4, with subsample splits at 1960:1-1979:3 and 1982:4-1993:4 (the 1979:4-1982:3 non-borrowed-reserves period is excluded from the subsamples because the Fed did not target the funds rate then). In a base three-variable VAR (output, prices, funds rate, Cholesky-ordered with the funds rate last), the price puzzle appears in the full sample and is much stronger in the pre-1980 subsample, where prices rise substantially for several years, than in the post-1982 subsample, where the funds rate’s effect on prices, though negative, is small and not statistically different from zero – a pattern the paper also confirms with a Romer and Romer (1989) narrative-shock distributed-lag approach. Adding commodity prices to the VAR (replicating Christiano, Eichenbaum, and Evans) eliminates the puzzle for the full sample and the post-1982 subsample but not the pre-1980 subsample, where prices remain above their original level for nearly three years; among the other candidate variables tested (oil prices, stock prices, unit labor costs, an index of leading indicators, capacity utilization, and individual short- and long-term rates), only the term spread (10-year Treasury bond rate minus 3-month Treasury bill rate) systematically helps resolve the puzzle, eliminating it in both subsamples when included alone – though not in the full sample, possibly because of extreme interest-rate volatility during 1979-82 – and eliminating it across all three samples when combined with commodity prices. Because the federal funds rate responds negatively, not positively, to a positive spread shock, the authors argue the data are inconsistent with Sims’s (1992) inflation-expectations explanation of the puzzle (which implies the Fed should tighten when the spread signals higher expected inflation), and instead favor a supply-shock explanation in which the Fed incompletely offsets the inflationary consequences of negative supply shocks that raise both commodity prices and the general price level while lowering output; the muted post-1982 puzzle is attributed to either the Fed placing more weight on price stability after Volcker or fewer severe supply shocks hitting the economy in the 1980s. Throughout, the paper reports one-standard-error rather than the more conventional two-standard-error confidence bands, understating the statistical uncertainty of its findings, and it is published as a Federal Reserve Bank policy review rather than a peer-reviewed journal article.

Federal Reserve Bank of Dallas Economic Review | Macro Paper Warehouse

Understanding the Price Puzzle