Assessing Changes in the Monetary Transmission Mechanism: A VAR Approach

This 2002 FRBNY Economic Policy Review paper by Jean Boivin and Marc Giannoni asks whether the transmission of monetary policy shocks to U.S. output and inflation changed after the early 1980s, and if so, whether the change reflects a shift in the propagation mechanism (how shocks work their way through the economy), a change in the size of shocks hitting the economy, or specifically a change in how the Federal Reserve systematically conducts policy. Using quarterly U.S. data from 1963:Q1 to 1997:Q4 on detrended output (a high-pass filter approximating the output gap), GDP-deflator inflation, commodity-price inflation (added to limit the price puzzle), and the federal funds rate, the authors estimate a four-variable, four-lag recursive (Cholesky) VAR in the Christiano-Eichenbaum-Evans (1999) style, ordering the funds rate last so it does not affect the other variables contemporaneously, and split the sample into pre-1980 (1963:Q1-1979:Q3), post-1980 (1980:Q1-1997:Q4), and post-1984 (1984:Q1-1997:Q4, excluding the 1979:Q4-1983:Q4 nonborrowed-reserves-targeting episode) sub-periods around the Volcker (1979:Q4) and McConnell-Perez-Quiros Great Moderation (1984:Q1) break dates. Andrews sup-Wald tests reject stability of the reduced-form VAR coefficients in 6 of 16 tests (38%), and chi-squared tests reject stability of the innovation covariance matrix in 5 of 8 tests overall (63%, pooling both break dates) — rejecting in all 4 of 4 variables at the 1979:Q3 break but only 1 of 4 at the 1984:Q1 break, indicating pervasive instability in both the propagation mechanism and shock variances. A reduced-form counterfactual variance decomposition finds that changed propagation coefficients account for roughly 38% (pre- vs. post-1980) or 22% (pre- vs. post-1984) of the decline in detrended-output variance, and roughly 58% (pre- vs. post-1980) or 56% (pre- vs. post-1984) of the decline in inflation variance, with the remainder attributed to reduced shock variance; the authors’ own rounded headline figures (“roughly 40 percent” for output, “60 percent” for inflation) refer specifically to the pre- vs. post-1980 comparison. Structural variance decompositions show monetary policy shocks’ contribution to output variance falling from 19% (pre-1980) to 7% (post-1980) to 3% (post-1984), and to inflation variance from 14% to 10% to 6%, even though the estimated variance of the policy shock itself is larger in the post-1980 sample (0.61 vs. 0.30 pre-1980, attributed to the 1979-83 nonborrowed-reserves episode) before falling to 0.14 post-1984 – suggesting the change concerns how policy shocks propagate, not merely their size. Impulse responses to an unexpected 1-percentage-point (100-basis-point) funds-rate increase are “much less pronounced and persistent” after 1980, with the output response trough “more than twice as large” pre-1980 as in either later sample. The paper’s central counterfactual then separates the model’s coefficients into a systematic-policy-rule block (denoted Phi) and a rest-of-economy block (denoted Omega), finding that replacing only the pre-1980 policy rule with the post-period rule (holding Omega fixed) reproduces the post-period impulse responses closely, whereas replacing only Omega “changes only little” – leading the authors to conclude that most of the reduction in output and inflation responses is accounted for by a change in the parameters characterizing systematic monetary policy. Via a simple IS-curve model they interpret this as more consistent with a more aggressive, stabilizing policy rule than with a genuine weakening of the interest-rate transmission channel, while explicitly noting that the VAR counterfactual alone cannot separately identify the two.

The Monetary Transmission Mechanism: Some Answers and Further Questions

This 2002 FRBNY Economic Policy Review article by Kenneth Kuttner and Patricia Mosser is a conference overview, not an original empirical study: it synthesizes papers presented at the Federal Reserve Bank of New York’s April 2001 conference “Financial Innovation and Monetary Transmission” to ask how Fed policy affects the economy and whether financial innovation has changed either the overall strength of monetary transmission or the channels through which it operates. The authors first lay out an “eclectic,” non-exclusive taxonomy of six transmission channels running from open market operations through reserves to the federal funds rate: the interest-rate channel (higher real rates raise the user cost of capital, though the authors note the macroeconomic response to policy-induced rate changes is “considerably larger than that implied by conventional estimates of the interest elasticities of consumption and investment,” pointing to additional channels), the wealth channel (rate changes affect asset values and hence household wealth and consumption), the broad credit or financial-accelerator channel (declining collateral values raise the external finance premium when credit markets have information or agency frictions), the narrow credit or bank-lending channel (reserve changes affect banks’ capacity to lend), the exchange-rate channel (often neglected in closed-economy US models), and the monetarist channel (relative asset-price effects from imperfect asset substitutability, relevant near the zero lower bound). They then identify three measurement challenges that complicate estimating any of these channels: simultaneity (the Fed eases when the economy weakens, so a raw correlation between the funds rate and growth over 1954-2000 is positive at short horizons and only turns negative after roughly a two-quarter lag, with the funds-rate/growth correlation across the whole sample near zero when comparing 1954-83 to 1984-2000 — a pattern consistent with either weaker policy or better stabilization); the difficulty of separating multiple concurrent channels operating together (e.g., disentangling a bank-lending-channel effect from a pure demand effect when both loans and output fall after a tightening); and slow-moving structural change (securitization, disintermediation, and financial consolidation evolved gradually, unlike the abrupt October 1979 operating-procedure shift, making standard structural-break tests poorly suited to detect them). Surveying the conference papers, Kuttner and Mosser report several specific findings attributed to those papers (not to themselves): Boivin and Giannoni’s VAR evidence that the decline in output volatility since the early 1980s reflects mainly a change in the systematic (“leaning against the wind”) component of the policy rule rather than a reduction in the variance of policy shocks, which Kahn-McConnell-Perez-Quiros dispute by attributing reduced output/inventory volatility instead to improved inventory management; Lown and Morgan’s finding that bank lending standards have predictive power for loan volume and output but that monetary policy has little effect on those standards, weakening support for the bank-lending channel; Estrella’s finding that securitization has significantly reduced the sensitivity of output and housing investment to the real funds rate even as mortgage-rate sensitivity to the funds rate has, if anything, increased; McCarthy and Peach’s finding that mortgage rates now respond faster to policy than before 1986 while residential investment responds more slowly and now moves concurrently with (rather than leading) overall activity; and Ludvigson, Steindel, and Lettau’s structural-VAR finding that the wealth channel is weak and, if anything, slightly weaker than in the 1960s-1970s, because asset-price responses to policy shocks are largely transitory and consumption responds mainly to permanent wealth changes. The authors draw three broad conclusions: monetary policy’s effects appear somewhat weaker than in past decades (attributable to financial innovation, better inventory management, and/or improved policy conduct, not to any single cause); the housing sector, once in the vanguard of transmission, now moves concurrently with the broader economy; and neither financial consolidation nor shrinking reserve volumes appear (as of 2002) to be major factors in transmission. They close by flagging three open questions the conference left unresolved: competing (securitization-based versus policy-based) explanations for reduced interest-rate sensitivity remain unreconciled; the causes of changes in securitized lending and housing finance “resist easy explanation”; and no conference paper addressed the exchange-rate channel at all, despite the growing role of net exports in US fluctuations — an explicit gap the authors flag rather than a finding.

FRBNY Economic Policy Review | Macro Paper Warehouse

Assessing Changes in the Monetary Transmission Mechanism: A VAR Approach

The Monetary Transmission Mechanism: Some Answers and Further Questions