James Hamilton reviews new research on “Summarizing monetary policy”:
Before 2008, U.S. monetary policy was primarily conducted in terms of a target set by the Federal Reserve for the fed funds rate, which is the interest rate a bank pays to borrow funds overnight from other banks. A large academic literature used the fed funds rate as a summary of monetary policy, looking at its correlations in dynamic regressions with other variables of macroeconomic interest. But the fed funds rate has been stuck near zero for the last 5 years, and will likely be replaced by an alternative policy focus even once we exit the zero lower bound. Economic researchers face not just the difficulty of summarizing what the Fed has been doing in the current and future environment, but also the practical challenge of how to update their historical regressions to try to describe the full set of historical data along with the new experience in a coherent way. Here I describe a new research paper that suggests one solution to these problems.
…This hypothesizes the existence of a “shadow” short-term interest rate that might in some circumstances be quite negative. In normal times (when the observed short-term interest rate is sufficiently high), this shadow rate is positive and coincides with the observed short rate, and the dynamic relations among interest rates of various maturities are described using familiar tools. The hypothesis is that when the shadow rate falls below some bound, we could continue to calculate an implied negative shadow rate as if it followed the usual historical dynamics as well as calculate forecasts for that shadow rate.
Of particular interest is Wu and Xia’s observation that their series for the shadow rate exhibits similar correlations with other macro variables since 2009 as the fed funds rate did in data up until the end of 2007. Wu and Xia took a popular model that had been estimated before the Great Recession in which the fed funds rate was used as the summary of monetary policy, and just replaced the fed funds rate with the Wu-Xia shadow rate to get a data set that continues after 2009. Although this device could not fully account for all that happened to interest rates and unemployment during the Great Recession over 2007-2009, Wu and Xia found the evidence to be consistent with the hypothesis that data since 2009 could be described using the spliced series as the monetary policy indicator and using the same model that described pre-2007 data. In other words, the shadow rate displays the same sort of correlation with lagged macro variables since 2009 as the fed funds rate did in earlier data, and likewise the value of macro variables that one would predict using the new shadow rate series is close to the value one would have predicted in earlier data using the fed funds rate instead.
The suggestion is that we then might use the shadow rate series as a way of summarizing what the Fed has been doing with its unconventional policy measures such as large-scale asset purchases and forward guidance. If the Wu-Xia framework is correct, these unconventional policies can all be summarized in terms of what effect they had on the shadow short rate. By comparing the shadow rate with the value that traditional models would have predicted for the fed funds rate, Wu and Xia get a measure of the shocks to monetary policy. Wu and Xia find that monetary policy has recently been a bit more expansionary than usual (pushing the shadow rate about 0.6% more negative over 2011-2013 than the traditional monetary policy rule would imply), as a result of which their estimates imply that the current unemployment rate is 0.23% lower than it otherwise would have been.
This is their chart:
I wish that instead of insisting in using interest rates, even if of the shadow variety, to pin the stance of monetary policy, studies would take other paths to that end, maybe studying alternatives like NGDP. Interestingly, it´s exactly the period covering 2007-09, when NGDP took a dive, that not even the shadow rate is capable of accounting for what happened!