Academic journal article Journal of Money, Credit & Banking

Has U.S. Monetary Policy Changed? Evidence from Drifting Coefficients and Real-Time Data

Academic journal article Journal of Money, Credit & Banking

Has U.S. Monetary Policy Changed? Evidence from Drifting Coefficients and Real-Time Data

Article excerpt

SINCE THE END of the great inflation of the 1970s, the U.S. has experienced only mild inflation and a considerable reduction in the volatility of real activity. (1) An important question is what, ultimately, brought about these improved economic outcomes.

One possible explanation is that the Federal Reserve changed its behavior in an important way. From a narrative perspective, this seems fairly uncontroversial, although the reasons for the changes might be more so. (2) The monetarist influence of the late 1970s, culminating in the "experiment" of 1979-82 under chairman Volcker, is often cited as an example. It has also been argued that the composition of the Federal Open Market Committee (FOMC) and other political pressures might have fundamentally altered monetary policy decisions over time. Further, the Fed might have learned from past experiences, changed its views about the economy, and, accordingly, modified its conduct of monetary policy. (3)

However, despite the large amount of empirical research on monetary policy rules, there is surprisingly little consensus on the nature or even the existence of these hypothesized changes.

Clarida, Gall, and Gertler (2000) provide empirical evidence of important changes in the U.S. conduct of monetary policy over the last 40 years. In particular, they find that while monetary policy accommodated inflation in the 1970s, this drastically and suddenly changed with the appointment of Volcker in 1979. They emphasize that the pre-Volcker conduct of monetary policy did not satisfy the so-called Taylor principle, so that a given increase in inflation was typically associated with a smaller increase in the nominal interest rate, thus resulting in a lower real interest rate. They argue that such behavior on the part of the Fed did not rule out nonfundamental fluctuations. Lubik and Schorfheide (2004) reach similar conclusions while formally testing for indeterminacy in the context of an estimated general equilibrium model.

This evidence has been challenged along three dimensions. First, Cogley and Sargent (2001) argue that the Fed's evolving views about the economy might have been more gradual. Cogley and Sargent (2001) specify a reduced form vector autoregression (VAR) with drifting coefficients which produces results, they argue, broadly consistent with those of Clarida, Gafi, and Gertler (2000), although the time variation is not clearly of a discrete nature. Second, Sims (2001) and Stock (2001) argue that Cogley and Sargent's (2001) conclusion might be contaminated by the presence of heteroskedasticity. This claim is supported in part by the evidence of Sims (1999) and Sims and Zha (2006), who find that most of the observed changes between the pre- and post-Volcker periods can be attributed to changes in the variance of the shocks. Yet, Cogley and Sargent (2005), extending their earlier model to allow for heteroskedasticity in the reduced form VAR shocks, still find important changes in the implied policy rule parameters. Finally, the evidence of changes in the conduct of monetary policy has also been challenged on the ground that it does not properly account for real-time issues, both in terms of the vintage of data used and the misperceptions about potential output. For instance, Orphanides (2001) argues that estimating monetary policy rules on ex post data, which were not available to policymakers in real-time, can lead to a very distorted picture of the historical conduct of monetary policy. Orphanides (2002) concludes that when the Clarida, Gali, and Gertler (2000) rule is estimated using real-time data on inflation and unemployment the conduct of monetary policy in the 1970s is not greatly different from the one thereafter. Orphanides (2003) reaches a similar conclusion, using real-time estimates of the output gap, except that he finds evidence of a reduction in the response to real activity. …

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