Narrative-Identification | Macro Paper Warehouse

A New Measure of Monetary Shocks: Derivation and Implications

This 2004 American Economic Review paper by Christina D. Romer and David H. Romer constructs a new narrative-based measure of monetary policy shocks designed to be free of both the endogenous response of policy to current economic conditions and the Federal Reserve’s anticipatory response to expected future developments – two contaminations the authors argue bias the federal funds rate as a policy indicator, pushing estimated output effects toward zero and generating a spurious “price puzzle.” Construction proceeds in two steps: first, reading the FOMC’s Record of Policy Actions and internal expected-rate memos for each scheduled meeting from March 1969 through December 1996 to identify the “intended” federal funds rate change at that meeting, excluding intermeeting moves and moves based on incorrect preliminary data; second, regressing these intended changes on the pre-meeting funds rate level and the Fed’s own Greenbook forecasts of output growth, inflation, and unemployment (levels and forecast revisions, one quarter before through two quarters after the meeting), with the residuals – estimated over 263 meetings, R-squared 0.28 – constituting the shock series. Aggregated to monthly frequency and entered with up to 36-48 lags in single-equation regressions for log industrial production and log PPI over January 1970-December 1996 (N=324), a one-percentage-point contractionary shock is estimated to reduce industrial production by a maximum of 4.3 percent after about 22 months (highly significant, t-statistics above 2.5 from month 17 through 27), an effect that becomes imprecisely estimated by month 48 (-1.7 percent, two-standard-error band -6.4 to +3.0); prices are essentially unaffected for roughly the first two years and then fall substantially, reaching -5.9 percent (t=5.5) at month 48, with no statistically significant price puzzle at any horizon – a sharp contrast with regressions using the actual funds rate, which produce a sustained roughly one-percent rise in prices over the same period. A three-variable recursive VAR (industrial production, PPI, cumulated shock) broadly confirms these patterns, with a smaller peak output effect (-2.9 percent) that the authors attribute to the VAR’s shock being transitory rather than the permanent shock assumed in the single-equation exercise. Controlling for world commodity prices changes results only modestly, which the authors read as evidence the measure is not substantially contaminated by responses to supply shocks; correcting for either endogeneity or anticipatory movements alone, by contrast, is shown to produce much smaller effects than correcting for both together. Central caveats: the sample is constrained to end in 1996 by the five-year Greenbook data embargo (excluding the later Greenspan tenure and the entire post-2008 zero-lower-bound period, to which the intended-funds-rate concept does not apply), a positive coefficient on the first lag of the shock in the output regression traces to a single April 1980 outlier that the authors attribute to sampling error, and the authors themselves flag the lag before prices begin to fall as the paper’s “most important uncertainty,” ranging from about six to twenty-two months across specifications.

Are the Effects of Monetary Policy Shocks Big or Small?

This 2012 American Economic Journal: Macroeconomics paper by Olivier Coibion asks why standard recursive VARs and the Romer-Romer (2004) narrative approach produce such different estimates of the real effects of monetary policy shocks, and argues the discrepancy is driven by three identifiable and largely correctable factors rather than genuine disagreement about the underlying policy shock. Using monthly US data (1970:1-1996:12, following Romer and Romer’s sample and variable choices), Coibion compares a standard recursive (Cholesky) VAR with the funds rate ordered last and 12 lags, the Romer-Romer single-equation approach (a macro variable regressed on 24 autoregressive lags and 36 lags of the R&R narrative shock series), and a “hybrid VAR” that replaces the funds rate in the VAR with the cumulative R&R shock series. At baseline lag specifications the three diverge sharply (Table 2, Panel A): a 100-basis-point shock produces a peak industrial production decline of about 0.7% and a 0.16 percentage-point rise in unemployment in the standard VAR, versus a 4.3% IP decline and 0.93 percentage-point unemployment rise in the R&R single-equation approach, with the hybrid VAR intermediate (1.6% IP decline, 0.40 points). Three mechanisms account for most of this gap: (1) an R&R shock corresponds to a larger, more persistent counterfactual path for the funds rate than a VAR Cholesky shock, and rescaling impulse responses to a common FFR path largely eliminates the difference; (2) R&R shocks during the 1979:10-1982:9 non-borrowed-reserves (NBR) targeting episode are statistically predictable from lagged macro variables (violating the shocks’ assumed exogeneity) and disproportionately drive the large R&R estimates; and (3) the R&R two-step procedure’s results rise nearly monotonically with the number of shock lags included, while AIC- or model-averaging-based lag selection picks shorter lags and shrinks the estimated effects (reducing the peak IP effect from -4.3% to -3.4%), whereas the VAR is comparatively insensitive to lag length. Once the NBR-targeting period is excluded and lag length is chosen by AIC or model averaging, the three approaches converge (Table 2, Panel B) on a “medium-range” peak effect of roughly a 1.8-2.8% industrial production decline and a 0.19-0.70 percentage-point unemployment increase; three additional Taylor-rule-residual shock measures constructed in Section III (GARCH, time-varying-coefficient, and Smets-Wouters DSGE-filtered shocks) corroborate this medium range and are markedly less sensitive to lag length or episode selection than the original R&R series, though the paper is explicit that its evidence covers only the pre-1997 sample and does not speak to the post-1996 or zero-lower-bound period.

Comments on "A New Measure of Monetary Shocks: Derivation and Implications"

These are John Cochrane’s discussant remarks, delivered July 17, 2004 at an NBER Economic Fluctuations and Growth meeting, on Christina Romer and David Romer’s “A New Measure of Monetary Shocks: Derivation and Implications” (published in the American Economic Review later that year). Cochrane opens by declaring he wants to argue the paper is “much better and deeper than the authors think it is,” identifying its two key innovations as extending the Fed’s intended (target) funds rate series back in time using historical “intentions” data, and, more importantly, establishing via narrative evidence that Federal Reserve staff Greenbook forecasts function as a “sufficient statistic” for the Fed’s information set at the time of each policy decision. Cochrane shows this sufficient-statistic property lets both halves of Romer-Romer’s procedure be radically simplified: identifying a valid policy shock requires only that it be orthogonal to the Fed’s own output forecast (not to price, exchange-rate, or other forecasts, since only reverse causality running through output needs to be purged), and once such a shock is in hand, the output or price response can be read directly off a sequence of single regressions rather than a full dynamic simulation with Monte Carlo standard errors. Re-estimating with his simplified shocks, Cochrane obtains essentially the same headline result as Romer-Romer – a 100-basis-point tightening produces a 6-8% decline in output peaking around 30 months out, with statistical significance only modestly above conventional thresholds (t-statistics “just above 2”) – alongside a “price puzzle” that he argues is not legitimately fixable by adding commodity prices to the shock regression, since the historical FOMC record shows no narrative evidence that the Fed actually responded to commodity-price movements in the way that fix presumes. He flags the response’s long delay and the near-total absence of any price response as jointly troubling for monetary theory, since most theories tie the two together. In a preliminary extension, Cochrane recomputes the output effect of a one-time, one-month target increase not followed by the Fed’s usual further tightening, and finds it roughly a tenth the size and considerably shorter-lived than the standard “full path” response – suggesting that whether anticipated policy actions matter is, in his view, at least as consequential a modeling choice as any other in this literature. He closes by suggesting the field’s next step should be estimating the Fed’s systematic policy rule directly (via narrative methods, since Fed statements arguably already summarize the rule) rather than continuing to refine shock-and-response estimates, and offers a conjecture that ordinary regression evidence cannot in principle distinguish a determinate (Taylor-rule-consistent) policy regime from an indeterminate one, because such regressions can only recover the stable root of the model’s dynamics, not the off-equilibrium explosive threats that actually enforce determinacy.

Unconventional but Different After All? A Unified Series of Narrative Monetary Policy Shocks

Asking whether unconventional monetary policy works differently from an interest-rate cut has been hard to answer because the two kinds of policy have been measured with different tools, so any difference in the estimated effects could be a difference in the measuring rather than in the policy. This paper builds one shock series for both, running Romer and Romer’s (2004) narrative regression — policy-rate changes on the Federal Reserve’s own Greenbook/Tealbook forecasts — but substituting Wu and Xia’s (2016) shadow rate for the federal funds rate over the 2009–16 zero-lower-bound period, which yields shocks for 1969–2008 and 2009–16 built the same way. Estimating local projections on the pooled sample with a structural break at the zero lower bound, the authors cannot reject equality of the peak responses of the interest rate, industrial production, unemployment and the consumer price index across regimes (p-values from 0.09 to 0.56), which they read as unconventional policy being about as effective as rate cuts for aggregate activity. Joint Wald tests do reject equality for wealth shares and for the stock-to-house price ratio, and the sign flips: an expansionary conventional shock normalised to 25 basis points lowers the top 10% wealth share by about 0.3% at the trough, while the equivalent unconventional shock raises it by up to about 0.36% and lowers the middle 40% share by about 0.7%. The authors attribute the difference to asset prices — unconventional easing raises the stock-to-house price ratio by over 3% where conventional easing lowers it by about 3.13% — and a mechanical revaluation of Survey of Consumer Finances portfolios reproduces the pattern, with the equity-heavy top 10% capturing most of the gains and households in the bottom groups, who hold little equity and often no housing, receiving comparatively little. The distributional evidence rests on short samples — 1989–2008 for conventional and 2009–15 for unconventional shocks, at quarterly frequency — and the authors do not address the Fed-information-effect and Fed-reaction-to-news concerns directly, assessing them only indirectly by comparison with shock series that are robust to them.