Research Summary
The report presents a comprehensive analysis of the Federal Open Market Committee’s (FOMC) monetary policy reaction function, using a Taylor rule with time-varying coefficients. The study reveals that the monetary policy rule has become more persistent and responsive to inflation since the pandemic. The report also explores the correlation between macroeconomic factors and changes in the policy rule coefficients, and how these changes impact bond markets.
Key Takeaways
Monetary Policy Rule’s Increased Persistence and Responsiveness to Inflation
- Post-Pandemic Shift: The report reveals that the monetary policy rule has become significantly more persistent and responsive to inflation following the pandemic. This shift indicates a strong reaction from the FOMC to counteract inflation deviations from the Committee’s target.
- Effective Lower Bound (ELB) Consideration: The model used in the report incorporates the ELB on the median federal funds rate projections, which is often omitted in similar studies. This inclusion allows for accurate predictions at the ELB during the pandemic.
- Shadow Federal Funds Rate: The report’s estimation technique produces a shadow federal funds rate at the end of each year, reaching about -2% during each of the two ELB episodes in the sample. This rate is used to gauge the monetary policy reaction function of the median FOMC participant.
Correlation Between Macroeconomic Factors and Policy Rule Coefficients
- Impact of Monetary Policy Cycles: The report finds that the expectation of a monetary policy tightening cycle affects all the coefficients of the Taylor rule, making it less persistent and less responsive to inflation but more sensitive to the output gap.
- Influence of Labor Market Conditions: The state of the labor market significantly impacts the responsiveness of the monetary policy rule. A weak current labor market leads to greater concern about economic activity and a more responsive monetary policy rule.
- Role of Macroeconomic Uncertainty: An increase in macroeconomic uncertainty leads to a higher sensitivity of the reaction function to inflation, possibly indicating a more hawkish stance of monetary policy to prevent losing control over inflation.
Impact of Policy Rule Changes on Bond Markets
- Bond Excess Returns: The report finds that a decrease in the persistence of the monetary policy rule or an increase in its reaction to inflation lowers bond excess returns, making them less risky. This suggests that Treasury bonds become better macroeconomic hedges in times of a less persistent policy rule or more responsiveness to inflation.
- Role of Inflation and Output Gap Coefficients: Changes in the inflation and output gap coefficients of the policy rule also impact bond excess returns. A higher inflation coefficient makes bonds riskier, while a higher persistence coefficient makes bonds less risky. However, variations in the output gap coefficient do not affect bond excess returns.
Comparison with Constant Coefficient Model
- Superior Predictive Accuracy: The report compares the proposed Taylor rule with time-varying coefficients with an alternative model with constant coefficients. The time-varying coefficient model shows superior predictive accuracy, particularly for the one-year ahead forecast, and accurately predicts instances when the SEP forecasts are at the ELB.
- Lower Forecast Error: The root-mean-squared forecast error (RMSFE) of the model with time-varying coefficients is lower than the model with constant coefficients for the one-, two-, and three-year ahead forecasts, further demonstrating the superior predictive accuracy of the time-varying coefficient model.
Implications for Future Research
- Need for Further Analysis: The report emphasizes the need for further research and analysis in the field of money, credit, and banking to enhance our understanding of the financial system and its implications for the economy.
- Policy Recommendations: The report concludes by suggesting policy recommendations to promote financial stability and economic growth, based on the findings of the study.
Actionable Insights
- Consider Time-Varying Coefficients: Policymakers and economists should consider the use of a Taylor rule with time-varying coefficients when analyzing the FOMC’s monetary policy reaction function. This approach provides a more accurate representation of the FOMC’s reaction function, particularly in periods of economic uncertainty such as the pandemic.
- Monitor Macroeconomic Factors: Policymakers should closely monitor macroeconomic factors such as labor market conditions and macroeconomic uncertainty, as these factors significantly correlate with changes in the policy rule coefficients. Understanding these correlations can help policymakers anticipate changes in the monetary policy rule and make more informed decisions.
- Assess Impact on Bond Markets: Investors and financial analysts should assess the impact of changes in the monetary policy rule on bond markets. Understanding how changes in the policy rule coefficients affect bond excess returns can help investors make more informed investment decisions.
- Explore Further Research Opportunities: Researchers should explore further opportunities for research in the field of money, credit, and banking. This could include investigating the impact of monetary policy on credit availability, the effectiveness of policy tools at the effective lower bound, and the measurement of uncertainty in monetary policy.
