Research Paper Abstracts

The Macroeconomic Effects of the Federal Reserve’s Conventional and Unconventional Monetary Policies,

I separately identify and estimate the effects of the Federal Reserve’s federal funds rate, forward guidance, and large-scale asset purchase (LSAP) policies on the U.S. economy. I extend the high-frequency identification strategy of Bauer and Swanson (2023b) for monetary policy VARs by allowing each of the above policies to have possibly different economic effects. I follow Swanson (2021) and Swanson and Jayawickrema (2023) to separately identify federal funds rate, forward guidance, and LSAP components of monetary policy announcements using high-frequency interest rate changes around FOMC announcements, post-FOMC press conferences, FOMC meeting minutes releases, and speeches and testimony by the Fed Chair and Vice Chair. I find that changes in the federal funds rate have had the most powerful effects on the U.S. economy, suggesting that the Fed and other central banks should continue to focus on short-term interest rates as their primary monetary policy tool going forward.

Speeches by the Fed Chair Are More Important than FOMC Announcements: An Improved High-Frequency Measure of U.S. Monetary Policy Shocks (with Vishuddhi Jayawickrema)

We extend the high-frequency monetary policy shock measures of Kuttner (2001) and Gürkaynak, Sack, and Swanson (2005a) to other major types of Fed communication beyond FOMC announcements, including post-FOMC-meeting press conferences, speeches and Congressional testimony by the Fed Chair and Vice Chair, and FOMC meeting minutes releases, all from 1988 to 2019. We find that speeches by the Fed Chair are more important than FOMC announcements for Treasury yields, stock prices, and all but the very shortest-maturity interest rate futures. Thus, previous studies’ focus on FOMC announcements has generally missed the most important source of variation in U.S. monetary policy. Post-FOMC press conferences have become more important over time and now also rival FOMC announcements in importance. FOMC minutes releases and Vice Chair speeches are not as important, but are still nonnegligible. We identify federal funds rate, forward guidance, and LSAP components for each of these announcement types and show that their effects are consistent across types.

The Labor Demand and Labor Supply Channels of Monetary Policy Transmission (with Sebastian Graves and Christopher Huckfeldt)

Monetary policy is conventionally understood to influence labor demand, with little effect on labor supply. Using high-frequency changes in interest rates around FOMC announcements and Fed Chair speeches, we find that contractionary monetary policy shocks lead to a significant increase in labor supply by reducing the rate at which workers quit jobs to non-employment and stimulating job-seeking behavior among the non-employed. Holding the response of supplydriven labor market flows fixed, the overall procyclical response of employment to monetary policy becomes nearly twice as large.

The Importance of Fed Chair Speeches as a Monetary Policy Tool

I estimate the effects of FOMC announcements, post-FOMC press conferences, and speeches and Congressional testimony by the Fed Chair on stock prices, Treasury yields, and interest rate futures from 1988–2019. I show that for all but the very shortest-maturity interest rate futures, Fed Chair speeches are more important than FOMC announcements. My results suggest that the previous literature’s focus on FOMC announcements has ignored the most important source of variation in U.S. monetary policy.

A Reassessment of Monetary Policy Surprises and High-Frequency Identification (with Michael Bauer)

High-frequency changes in interest rates around FOMC announcements are an important tool for identifying the effects of monetary policy on asset prices and the macroeconomy. However, some recent studies have questioned both the exogeneity and the relevance of these monetary policy surprises as instruments, especially for estimating the macroeconomic effects of monetary policy shocks. For example, monetary policy surprises are correlated with macroeconomic and financial data that is publicly available prior to the FOMC announcement. We address these concerns in two ways: First, we expand the set of monetary policy announcements to include speeches by the Fed Chair, which doubles the number and importance of announcements; Second, we explain the predictability of the monetary policy surprises in terms of the “Fed response to news” channel of Bauer and Swanson (2021) and account for it by orthogonalizing the surprises with respect to macroeconomic and financial data that pre-date the announcement. Our subsequent reassessment of the effects of monetary policy yields two key results: First, estimates of the high-frequency effects on asset prices are largely unchanged; Second, estimates of the effects on the macroeconomy are substantially larger and more significant than what previous studies using high-frequency data have typically found.

The Federal Funds Market, Pre- and Post-2008

This chapter provides an overview of the federal funds market and how the equilibrium federal fund rate is determined. I devote particular attention to comparing and contrasting the federal funds market before and after 2008, since there were several dramatic changes around that time that completely changed the market and the way in which the equilibrium federal funds rate is determined. The size of this structural break is arguably as large and important as the period of reserves targeting under Fed Chairman Paul Volcker from 1979–82. Finally, I discuss the relationship between the federal funds rate and other short-term interest rates in the U.S. and the outlook for the federal funds market going forward.

An Alternative Explanation for the “Fed Information Effect” (with Michael Bauer) (previous versions circulated under the title The Fed’s Response to Economic News Explains the “Fed Information Effect”)

High-frequency changes in interest rates around FOMC announcements are a standard method of measuring monetary policy shocks. However, some recent studies have documented puzzling effects of these shocks on private-sector forecasts of GDP, unemployment, or inflation that are opposite in sign to what standard macroeconomic models would predict. This evidence has been viewed as supportive of a “Fed information effect” channel of monetary policy, whereby an FOMC tightening (easing) communicates that the economy is stronger (weaker) than the public had expected. We show that these empirical results are also consistent with a “Fed response to news” channel, in which incoming, publicly available economic news causes both the Fed to change monetary policy and the private sector to revise its forecasts. We provide substantial new evidence that distinguishes between these two channels and strongly favors the latter; for example, (i) regressions that include the previously omitted public economic news, (ii) a new survey that we conduct of Blue Chip forecasters, and (iii) high-frequency financial market responses to FOMC announcements all indicate that the Fed and private sector are simply responding to the same public news, and that there is little if any role for a “Fed information effect”.

The Federal Reserve Is Not Very Constrained by the Lower Bound on Nominal Interest Rates

I survey the literature on monetary policy at the zero lower bound (ZLB) and effective lower bound (ELB) to make three main points: First, the Federal Reserve’s forward guidance and large-scale asset purchases are effective monetary policy tools at the Z/ELB. Second, during the 2008–15 U.S. ZLB period, the Fed was not very constrained in its ability to influence medium- and longer-term interest rates and the economy. Third, the risks of the Fed being significantly constrained by the ELB in the future are typically greatly overstated. I conclude that the Federal Reserve is not very constrained by the lower bound on nominal interest rates.

Measuring the Effects of Federal Reserve Forward Guidance and Asset Purchases on Financial Markets

I extend the methods of Gürkaynak, Sack, and Swanson (2005a) to separately identify surprise changes in the federal funds rate, forward guidance, and large-scale asset purchases (LSAPs) on FOMC announcement days. I show that forward guidance and LSAPs had substantial and highly statistically significant effects on Treasury yields, corporate bond yields, stock prices, and exchange rates, comparable in magnitude to the effects of the federal funds rate in normal times. Forward guidance was more effective than LSAPs at moving short-term Treasury yields and stocks, while LSAPs were more effective than forward guidance and the federal funds rate at moving longer-term Treasury and corporate bond yields. These effects were all very persistent, with the exception of the very large and perhaps special March 2009 “QE1’ announcement for LSAPs.

Measuring the Effects of Unconventional Monetary Policy on Asset Prices

I adapt the methods of Gürkaynak, Sack, and Swanson (2005) to estimate two dimensions of monetary policy during the 2009–2015 zero lower bound period in the U.S. I show that, after a suitable rotation, these two dimensions can be interpreted as “forward guidance” and “large-scale asset purchases” (LSAPs). I estimate the sizes of the forward guidance and LSAP components of each FOMC announcement between January 2009 and June 2015, and show that those estimates correspond closely to identifiable features of major FOMC announcements over that period. Forward guidance has relatively small effects on the longest maturity Treasury yields and essentially no effect on corporate bond yields, while LSAPs have large effects on those yields but essentially no effect on short-term Treasuries. Both types of policies have significant effects on medium-term Treasury yields, stock prices, and exchange rates.

A Macroeconomic Model of Equities and Real, Nominal, and Defaultable Debt

Linkages between the real economy and financial markets can be extremely important, as demonstrated by the the recent global financial crisis and European sovereign debt crisis. In this paper, I develop a simple, structural macroeconomic model that is consistent with a wide variety of asset pricing facts, such as the size and variability of risk premia on equities, real and nominal government bonds, and corporate bonds—the equity premium puzzle, bond premium puzzle, and credit spread puzzle, respectively. I thus show how to unify a variety of asset pricing puzzles from finance into a simple, structural framework. Conversely, I show how to bring standard macroeconomic models into agreement with a wide range of asset pricing facts.

Monetary Policy Effectiveness in China: Evidence from a FAVAR Model (with John Fernald and Mark Spiegel)

We use a broad set of Chinese economic indicators and a dynamic factor model framework to estimate Chinese economic activity and inflation as latent variables. We incorporate these latent variables into a factor-augmented vector autoregression (FAVAR) to estimate the effects of Chinese monetary policy on the Chinese economy. A FAVAR approach is particularly well-suited to this analysis due to concerns about Chinese data quality, a lack of a long history for many series, and the rapid institutional and structural changes that China has undergone. We find that increases in bank reserve requirements reduce economic activity and inflation, consistent with previous studies. In contrast to much of the literature, however, we find that central-bank determined changes in Chinese interest rates also have substantial impacts on economic activity and inflation, while other measures of changes in credit conditions, such as shocks to M2 or lending levels, do not once other policy variables are taken into account. Overall, our results indicate that the monetary policy transmission channels in China have moved closer to those of Western market economies.

Measuring the Effect of the Zero Lower Bound on Yields and Exchange Rates in the U.K. and Germany (with John Williams)

The zero lower bound on nominal interest rates began to constrain many central banks’ setting of short-term interest rates in late 2008 or early 2009. According to standard macroeconomic models, this should have greatly reduced the effectiveness of monetary policy and increased the efficacy of fiscal policy. However, these models also imply that asset prices and private-sector decisions depend on the entire path of expected future short-term interest rates, not just the current level of the monetary policy rate. Thus, interest rates with a year or more to maturity are arguably more relevant for asset prices and the economy, and it is unclear to what extent those yields have been affected by the zero lower bound. In this paper, we apply the methods of Swanson and Williams (2013) to medium- and longer-term yields and exchange rates in the U.K. and Germany. In particular, we compare the sensitivity of these rates to macroeconomic news during periods when short-term interest rates were very low to that during normal times. We find that: 1) USD/GBP and USD/EUR exchange rates have been essentially unaffected by the zero lower bound, 2) yields on German bunds were essentially unconstrained by the zero bound until late 2012, and 3) yields on U.K. gilts were substantially constrained by the zero lower bound in 2009 and 2012, but were surprisingly responsive to news in 2010--11. We compare these findings to the U.S. and discuss their broader implications.

Implications of Labor Market Frictions for Risk Aversion and Risk Premia

A flexible labor margin allows households to absorb shocks to asset values with changes in hours worked as well as changes in consumption. This ability to partially offset wealth shocks by varying hours of work can significantly alter the household’s attitudes toward risk, as shown in Swanson (2012). In this paper, I analyze how frictional labor markets affect that analysis. Household risk aversion (as measured by willingness to pay to avoid a wealth shock) is higher: 1) in countries with more frictional labor markets, 2) in recessions, and 3) for households that have more difficulty finding a job. These predictions are consistent with empirical evidence from a variety of sources. Quantitatively, I show that labor market frictions in Europe are large enough to play a substantial contributing role to risk aversion in those countries. Nevertheless, labor markets in the U.S. and Europe are flexible enough that risk aversion in these countries is much closer to the frictionless benchmark in Swanson (2012) than to traditional measures that assume labor is fixed.

Risk Aversion, Risk Premia, and the Labor Margin with Generalized Recursive Preferences

A flexible labor margin allows households to absorb shocks to asset values with changes in hours worked as well as changes in consumption. This ability to absorb shocks along both margins greatly alters the household’s attitudes toward risk, as shown by Swanson (2012). The present paper extends that analysis to the case of generalized recursive preferences, as in Epstein and Zin (1989) and Weil (1989), including multiplier preferences, as in Hansen and Sargent (2001). Understanding risk aversion for these preferences is especially important becasue they are the primary mechansim being used to bring macroeconomic models into closer agreement with asset pricing facts. Measures of risk aversion commonly used in the literature—including traditional, fixed-labor measures and Cobb-Douglas composite good measures—show no stable relationship to the equity premium in a standard macroeconomic model, while the closed-form expressions derived in this paper match the equity premium closely. Thus, measuring risk aversion correctly—taking into account the household’s labor margin—is necessary for risk aversion to correspond to asset prices in the model.

Measuring the Effect of the Zero Lower Bound on Medium- and Longer-Term Interest Rates (with John Williams)

The federal funds rate has been at the zero lower bound for over four years, since December 2008. According to standard macroeconomic models, this should have greatly reduced the effectiveness of monetary policy and increased the efficacy of fiscal policy. However, these models also imply that asset prices and private-sector decisions depend on the entire path of expected future short-term interest rates, not just the current level of the overnight rate. Thus, interest rates with a year or more to maturity are arguably more relevant for asset prices and the economy, and it is unclear to what extent those yields have been affected by the zero lower bound. In this paper, we measure the effects of the zero lower bound on interest rates of any maturity by comparing the sensitivity of those interest rates to macroeconomic news when short-term interest rates were very low to that during normal times. We find that yields on Treasury securities with a year or more to maturity were surprisingly responsive to news throughout 2008&endash;10, suggesting that monetary and fiscal policy were likely to have been about as effective as usual during this period. Only beginning in late 2011 does the sensitivity of these yields to news fall closer to zero. We offer two explanations for our findings: First, until late 2011, market participants expected the funds rate to lift off from zero within about four quarters, minimizing the effects of the zero bound on medium- and longer-term yields. Second, the Fed’s unconventional policy actions seem to have helped offset the effects of the zero bound on medium- and longer-term rates.

Let’s Twist Again: A High-Frequency Event-Study Analysis of Operation Twist and Its Implications for QE2

This paper undertakes a modern event-study analysis of Operation Twist and compares its effects to those that should be expected for the recent quantitative policy announced by the Federal Reserve, dubbed “QE2”. We first show that Operation Twist and QE2 are similar in magnitude. We identify five significant, discrete announcements in the course of Operation Twist that potentially could have had a major effect on financial markets, and show that three did have statistically significant effects. The cumulative effect of these five announcements on longer-term Treasury yields is highly statistically significant but moderate, amounting to about 15 basis points. This estimate is consistent both with Modigliani and Sutch’s (1966) time series analysis and with the lower end of empirical estimates of Treasury supply effects in the literature.

Risk Aversion and the Labor Margin in Dynamic Equilibrium Models

The household’s labor margin has substantial effects on risk aversion, and hence asset prices, in dynamic equilibrium models even when utility is additively separable between consumption and labor. This paper derives simple, closed-form expressions for risk aversion that take into account the household’s labor margin. Ignoring this margin can dramatically overstate the household’s true aversion to risk. Risk premia on assets priced with the stochastic discount factor increase essentially linearly with risk aversion, so measuring risk aversion correctly is crucial for asset pricing in the model.

The Bond Premium in a DSGE Model with Long-Run Real and Nominal Risks (with Glenn Rudebusch)

The term premium on nominal long-term bonds in the standard dynamic stochastic general equilibrium (DSGE) model used in macroeconomics is far too small and stable relative to empirical measures obtained from the data—an example of the “bond premium puzzle.” However, in models of endowment economies, researchers have been able to generate reasonable term premiums by assuming that investors have recursive Epstein-Zin preferences and face long-run economic risks. We show that introducing Epstein-Zin preferences into a canonical DSGE model can also produce a large and variable term premium without compromising the model’s ability to fit key macroeconomic variables. Long-run nominal risks further improve the model’s ability to fit the data, but do not substantially reduce the model’s need for a high level of household risk aversion.

Examining the Bond Premium Puzzle with a DSGE Model (with Glenn Rudebusch)

The basic inability of standard theoretical models to generate a sufficiently large and variable nominal bond risk premium has been termed the “bond premium puzzle”. We show that the term premium on long-term bonds is far too small and stable relative to the data in the canonical dynamic stochastic general equilibrium (DSGE) model used in macroeconomics. We find that introducing long-memory habits in consumption as well as labor market frictions can help fit the term premium, but only by seriously distorting the DSGE model’s ability to fit other macroeconomic variables, such as the real wage; therefore, the bond premium puzzle remains.

Convergence and Anchoring of Yield Curves in the Euro Area (with Michael Ehrmann, Marcel Fratzscher, and Refet Gürkaynak)

We study the convergence of European bond markets and the anchoring of inflation expectations in the euro area using high-frequency bond yield data for France, Germany, Italy, and Spain as well as smaller euro area countries and a control group comprising the UK, Denmark, and Sweden. We find that Economic and Monetary Union (EMU) has led to substantial convergence in euro area sovereign bond markets in terms of interest rate levels, unconditional daily fluctuations, and conditional responses to major macroeconomic announcements. Our findings also suggest a substantial increase in the anchoring of long-term inflation expectations since EMU, particularly for Italy and Spain, which have seen their long-term interest rates become much lower, much less volatile, and much better anchored in response to news. Finally, we present evidence that the elimination of exchange rate risk and the adoption of a common monetary policy were the primary drivers of bond market convergence in the euro area, as opposed to fiscal policy restraint and the loose exchange rate peg of the 1990s.

Macroeconomic Implications of Changes in the Term Premium (with Glenn Rudebusch and Brian Sack)

Linearized New Keynesian models and empirical no-arbitrage, macro-finance models offer little insight regarding the implications of changes in bond term premiums for economic activity. We investigate these implications using both a structural model and a reduced-form framework. We show that there is no structural relationship running from the term premium to economic activity, but a reduced-form empirical analysis does suggest that a decline in the term premium has typically been associated with stimulus to real economic activity, which contradicts earlier results in the literature.

Bayesian Optimal Policy in the Presence of Regime Change and Local Parameter Uncertainty

This paper proposes an approximation to the optimal policy problem in forward-looking models with regime change that allows for tractable solution for the optimal policy even when the parameters of the model and the current regime are not known with certainty. The linear-quadratic framework is adhered to as much as possible, with a particular emphasis on maintaining the property of separation of estimation and control, which is crucial for maintaining tractability. Generality is achieved by allowing for full Bayesian updating of all aspects of the model, including model parameters, the probability that a regime change has occurred, and the values of all (generally non-normal) shocks hitting the model each period. The methods of this paper provide results that can be quite useful in practice—for example, they fit the policy behavior of the Federal Reserve in the late 1990s very well, which standard methods fail to do.

The Bond Yield “Conundrum” from a Macro-Finance Perspective (with Glenn Rudebusch and Tao Wu)

In 2004 and 2005, long-term interest rates remained remarkably low despite improving economic conditions and rising short-term interest rates, a situation that former Fed Chairman Alan Greenspan dubbed a “conundrum.” We document the extent and timing of this conundrum using two empirical no-arbitrage macro-finance models of the term structure of interest rates. These models confirm that the recent behavior of long-term yields has been unusual—that is, it cannot be explained within the framework of the models. Therefore, we consider other macroeconomic factors omitted from the models and find that some of these variables, particularly declines in long-term bond volatility, may explain a portion of the conundrum. Foreign official purchases of U.S Treasuries appear to have played little or no role.

Inflation Targeting and the Anchoring of Inflation Expectations in the Western Hemisphere (with Refet Gürkaynak, Andrew Levin, and Andrew Marder)

We investigate the extent to which long-run inflation expectations are well anchored in three western hemisphere countries—Canada, Chile, and the United States—using a high-frequency event-study analysis. Specifically, we use daily data on far-ahead forward inflation compensation—the difference between forward rates on nominal and inflation-indexed bonds—as an indicator of financial market perceptions of inflation risk and the expected level of inflation at long horizons. For the United States, we find that far-ahead forward inflation compensation has reacted significantly to macroeconomic data releases, suggesting that long-run inflation expectations have not been completely anchored. In contrast, the Canadian inflation compensation data have exhibited significantly less sensitivity to Canadian and U.S. macroeconomic news, suggesting that inflation targeting in Canada has helped to anchor long-run inflation expectations in that country. Finally, while the requisite data for Chile are only available for a limited sample period (2002-2005), our results are consistent with the hypothesis that inflation targeting in Chile helped anchor long-run inflation expectations in that country as well.

Does Inflation Targeting Anchor Long-Run Inflation Expectations? Evidence from Long-Term Bond Yields in the U.S., U.K., and Sweden (with Refet Gürkaynak and Andrew Levin)

We investigate the extent to which inflation expectations have been more firmly anchored in the United Kingdom—a country with an explicit inflation target—than in the United States—which has no such target—using the difference between far-ahead forward rates on nominal and inflation-indexed bonds as a measure of compensation for expected inflation and inflation risk at long horizons. We show that far-ahead forward inflation compensation in the U.S. exhibits substantial volatility, especially at low frequencies, and displays a highly significant degree of sensitivity to economic news. Similar patterns are evident in the U.K. prior to 1997, when the Bank of England was not independent, but have been strikingly absent since the Bank of England gained independence in 1997. Our findings are further supported by comparisons of dispersion in longer-run inflation expectations of professional forecasters and by evidence from Sweden, another inflation targeting country with a relatively long history of inflation-indexed bonds. Our results support the view that an explicit and credible inflation target helps to anchor the private sector’s views regarding the distribution of long-run inflation outcomes.

Optimal Time-Consistent Monetary Policy in the New Keynesian Model with Repeated Simultaneous Play (with Gauti Eggertsson)

We solve for the optimal time-consistent monetary policy in the New Keynesian model with repeated simultaneous play between the monetary authority, households, and firms. Recent work on optimal time-consistent monetary policy has emphasized the existence of multiple Markov perfect equilibria in the New Keynesian model (e.g., King and Wolman, 2004). In this paper, we show that this multiplicity is not intrinsic to the New Keynesian model itself, but is instead driven by a special timing assumption by previous authors that play is “ repeated Stackelberg”—in which case the monetary authority must pre-commit each period to a value for the monetary instrument—as opposed to repeated simultaneous, in which case the monetary authority and the private sector determine the economic equilibrium simultaneously and jointly every period. To illlustrate this, we derive a closed-form solution for the set of all possible Markov perfect equilibria in the two-period Taylor contracting version of the New Keynesian model under repeated simultaneous play and show that the equilibrium in that model is unique.

Do Actions Speak Louder Than Words? The Response of Asset Prices to Monetary Policy Actions and Statements (with Refet Gürkaynak and Brian Sack)

We investigate the effects of U.S. monetary policy on asset prices using a high-frequency event-study analysis. We test whether these effects are adequately captured by a single factor—changes in the federal funds rate target—and find that they are not. Instead, we find that two factors are required. These factors have a structural interpretation as a “current federal funds rate target” factor and a “future path of policy” factor, with the latter closely associated with FOMC statements. We measure the effects of these two factors on bond yields and stock prices using a new intraday dataset going back to 1990. According to our estimates, both monetary policy actions and statements have important but differing effects on asset prices, with statements having a much greater impact on longer-term Treasury yields.

Futures Prices as Risk-Adjusted Forecasts of Monetary Policy (with Monika Piazzesi)

Many researchers have used federal funds futures rates as measures of financial markets’ expectations of future monetary policy. However, to the extent that federal funds futures reflect risk premia, these measures require some adjustment to account for these premia. In this paper, we document that excess returns on federal funds futures have been positive on average and strongly countercyclical. In particular, excess returns are surprisingly well predicted by macroeconomic indicators such as employment growth and financial business-cycle indicators such as Treasury yield spreads and corporate bond spreads. Excess returns on eurodollar futures display similar patterns. We document that simply ignoring these risk premia has important consequences for the expected future path of monetary policy. We also show that risk premia matter for some futures-based measures of monetary policy surprises used in the literature.

Have Increases in Federal Reserve Transparency Improved Private-Sector Interest Rate Forecasts?

Yes. This paper shows that, since the late 1980s, U.S. financial markets and private sector forecasters have become: 1) better able to forecast the federal funds rate at horizons out to several months, 2) less surprised by Federal Reserve announcements, 3) more certain of their interest rate forecasts ex ante, as measured by interest rate options, and 4) less diverse in the cross-sectional variety of their interest rate forecasts. We also present evidence that strongly suggests increases in Federal Reserve transparency played a role: for example, private sector forecasts of GDP and inflation have not experienced similar improvements over the same period, indicating that the improvement in interest rate forecasts has been special.

Higher-Order ‘Perturbation’ Solutions to Dynamic, Discrete-Time Rational Expectations Models (with Gary Anderson and Andrew Levin)

We present an algorithm and software routines for computing nth-order Taylor series approximate solutions to dynamic, discrete-time rational expectations models around a nonstochastic steady state. The primary advantage of higher-order (as opposed to first- or second-order) approximations is that they are valid not just locally, but often globally (i.e., over nonlocal, possibly very large compact sets) in a rigorous sense that we specify. We apply our routines to compute first- through seventh-order approximate solutions to two standard macroeconomic models, a stochastic growth model and a life-cycle consumption model, and discuss the quality and global properties of these solutions.

The Sensitivity of Long-Term Interest Rates to Economic News: Evidence and Implications for Macroeconomic Models (with Refet Gürkaynak and Brian Sack)

This paper demonstrates that long-term forward interest rates in the U.S. often react considerably to surprises in macroeconomic data releases and monetary policy announcements. This behavior is in contrast to the prediction of many macroeconomic models, in which the long-run properties of the economy are assumed to be time-invariant and perfectly known by all economic agents: Under those assumptions, the shocks we consider would have only transitory effects on short-term interest rates, and hence would not generate large responses in forward rates. Our empirical findings suggest that private agents adjust their expectations of the long-run inflation rate in response to macroeconomic and monetary policy surprises. We present an alternative model that captures this behavior. Consistent with our hypothesis, forward rates derived from inflation-indexed Treasury debt show little sensitivity to these shocks, indicating that the response of nominal forward rates is mostly driven by inflation compensation.

Market-Based Measures of Monetary Policy Expectations (with Refet Gürkaynak and Brian Sack)

A number of recent papers have used different financial market instruments to measure near-term expectations of the federal funds rate and have used high-frequency changes in these instruments around FOMC announcements to measure monetary policy shocks. This paper evaluates the empirical success of a variety of financial market instruments in predicting the future path of monetary policy. All of the instruments we consider provide forecasts that are clearly superior to those of standard time series models at all of the horizons considered. Among financial market instruments, we find that federal funds futures dominate all the other securities in forecasting monetary policy at horizons out to six months. For longer horizons, the predictive power of many of the instruments we consider is very similar. In addition, we present evidence that monetary policy shocks computed using the current-month federal funds futures contract are influenced by changes in the timing of policy actions that do not influence the expected course of policy beyond a horizon of about six weeks. We propose an alternative shock measure that captures changes in market expectations of policy over slightly longer horizons.

Do Federal Reserve Policy Surprises Reveal Superior Information About the Economy? (with Jon Faust and Jonathan Wright)

A number of recent papers have hypothesized that the Federal Reserve possesses information about the course of inflation and output that is unknown to the private sector, and that policy actions by the Federal Reserve convey some of this superior information. We conduct two tests of this hypothesis: 1) could monetary policy surprises be used to improve the private sector’s ex ante forecasts of subsequent macroeconomic statistical releases, and 2) does the private sector revise its forecasts of macroeconomic statistical releases in response to these monetary policy surprises? We find little evidence that Federal Reserve policy surprises convey superior information about the state of the economy: they could not systematically be used to improve forecasts of statistical releases and forecasts are not systematically revised in response to policy surprises. One possible exception to this pattern is Industrial Production, a statistic that the Federal Reserve produces.

Identifying the Effects of Monetary Policy Shocks on Exchange Rates Using High-Frequency Data (with Jon Faust, John Rogers, and Jonathan Wright)

In this paper, we bring high-frequency financial market data to bear to identify the monetary policy shocks following the approach of Faust, Swanson, and Wright (2002). The approach begins by calculating changes in exchange rates, interest rates, and interest rate futures in a narrow window around announced Federal Open Market Committee (FOMC) policy moves. We assume that these high-frequency changes are driven by the unexpected component of the FOMC decision and give a measure of the impulse response of these variables to the policy shock. We then impose that the impulse responses of the exchange rate and U.S. and foreign short-term interest rates in a standard open-economy VAR match the responses we have estimated from the high-frequency financial market data. For Germany, we formally reject the recursive identification, but we are unable to reject the recursive ordering for the U.K. Our impulse responses and variance decompositions qualitatively agree with those obtained from the usual recursive identification, although we find less evidence of a “price puzzle” and more persistent effects of monetary policy on domestic and foreign output. We are also able to estimate contemporaneous effects of U.S. monetary policy shocks on exchange rates and foreign interest rates.

Identifying VARs Based on High-Frequency Futures Data (with Jon Faust and Jonathan Wright)

Using prices from federal funds futures contracts, we derive the unexpected component of Federal Reserve policy decisions and assess their impact on the future trajectory of interest rates. We show how this information can be used to identify the effects of a monetary policy shock within a standard monetary policy VAR. We find that the usual recursive identification used in the literature is rejected, but we nevertheless agree with the literature’s conclusion that only a small fraction of the variance of output is due to monetary policy shocks.

NAIRU Uncertainty and Nonlinear Policy Rules (with Laurence Meyer and Volker Wieland)

Meyer (1999) has suggested that episodes of heightened uncertainty about the NAIRU may warrant a nonlinear policy response to changes in the unemployment rate. This paper offers a theoretical justification for such a nonlinear policy rule, and provides some empirical evidence on the relative performance of linear and nonlinear rules when there is heightened uncertainty about the NAIRU.

Econometric Estimation when the “True” Model Errors Are Observed

Stochastic disturbance terms in an econometric model encompass two types of error: 1) specification error resulting from an econometric model that is simpler than the “true” economic model, and 2) stochastic innovations to the “true” economic model. It is standard practice to minimize these composite errors to estimate the econometric model. In many interesting cases, however, the “true” model forecasts or errors can be regarded as observed through futures markets, prediction markets, or surveys of professional forecasters. When the true model forecasts or errors are observed, econometric estimation can be improved by minimizing the distance from the econometric model’s residuals to the true model errors, rather than to a vector of zeros. This paper derives the theory and applies the method to estimate simple time series models. The error-matching estimation method prescribed by this paper avoids overweighting large model errors that were unforecastable ex ante, and reduces standard errors substantially, by about 20–40% for the simple time series examples considered.

Optimal Nonlinear Policy: Signal Extraction with a Non-Normal Prior

The literature on optimal monetary policy typically makes three major assumptions: 1) policymakers’ preferences are quadratic, 2) the economy is linear, and 3) stochastic shocks and policymakers’ prior beliefs about unobserved variables are normally distributed. This paper relaxes the third assumption and explores its implications for optimal policy. The separation principle continues to hold in this framework, allowing for tractability and application to forward-looking models, but policymakers’ beliefs are no longer updated in a linear fashion, allowing for plausible nonlinearities in optimal policy. We consider in particular a class of models in which policymakers’ priors about the natural rate of unemployment are diffuse in a region around the mean. When this is the case, it is optimal for policy to respond cautiously to small surprises in the observed unemployment rate, but become increasingly aggressive at the margin. These features of optimal policy match statements by Federal Reserve officials and the behavior of the Fed in the 1990s.

Signal Extraction and Non-Certainty-Equivalence in Optimal Monetary Policy Rules

A standard result in the literature on monetary policy rules is that of certainty-equivalence: Given the expected values of the state variables of the economy, policy should be independent of all higher moments of those variables. Some exceptions to this rule have been pointed out in the literature, including restricting the policy response to a limited subset of state variables, or to estimates of the state variables that are biased. In contrast, this paper studies fully optimal policy rules with optimal estimation of state variables. The rules in this framework exhibit certainty-equivalence with respect to estimates of an unobserved state variable (“excess demand”) X, but are not certainty-equivalent when (i) X must be estimated by signal extraction and (ii) the optimal rule is expressed as a reduced form that combines policymakers’ estimation and policy-setting stages. I find that it is optimal for policymakers to attenuate their reaction to a variable about which uncertainty has increased, while responding more aggressively to variables about which uncertainty has not changed.

The Relative Price and Relative Productivity Channels for Aggregate Fluctuations

This paper demonstrates that sectoral heterogeneity itself—without any additional bells or whistles—has first-order implications for the transmission of aggregate shocks to aggregate variables in an otherwise standard DSGE model. The effects of sectoral heterogeneity on this transmission are decomposed into two channels: a “relative price” channel and a “relative productivity” channel. The relative price channel results from changes in the relative prices of aggregates, such as investment vis-a-vis consumption goods, which occurs in a sectoral model in response to even standard aggregate shocks. The relative productivity channel arises from changes in the distribution of inputs across sectors. We show that, for standard sectoral models, this latter channel is second-order, but becomes first-order if we consider a nontraded input such as capital utilization or introduce a wedge that thwarts the steady-state equalization of marginal products of a traded input across sectors. For reasonable parameterizations, the relative productivity channel causes aggregate productivity to vary procyclically in response to non-technological shocks such as changes in government purchases.

Measuring the Cyclicality of Real Wages: How Important is the Firm’s Point of View?

There is a growing consensus among economists that real wages in the postwar U. S. have been moderately to strongly procyclical, particularly in panel data on workers. This has greatly bolstered technology-driven theories of business cycles at the expense of more Classical models. This paper makes the point that technological movements in firm’s labor demand should be tested with a wage that is deflated by the firm’ own price of output, with appropriate controls for intermediate inputs, and with respect to the cyclical state of the firm’s own industry, as opposed to the state of the aggregate economy. Failure to control for these factors is found to lead to substantial over-rejection of the Classical model. In detailed industry data, with controls for changes in worker composition, I find that a vast majority of sectors have paid real product wages that vary inversely (i.e., countercyclically) with the state of their industry.

Real Wage Cyclicality in the PSID

Previous studies of real wage cyclicality have made only sparing use of the micro-data detail that is available in the Panel Study of Income Dynamics (PSID). The present paper brings to bear this additional detail to investigate the robustness of previous results and to examine whether there are important cross-sectional and demographic differences in wage cyclicality. Although real wages were procyclical across the entire distribution of workers from 1967 to 1991, the wages of lower-income, younger, and less-educated workers exhibited greater procyclicality. However, workers’ straight-time hourly pay rates have been acyclical, suggesting that more variable pay margins such as bonuses, overtime, late shift premia, and commissions have played a substantial if not primary role in generating procyclicality.