Friday, October 18, 2013

Identifying monetary policy "shocks"

I have always found the empirical monetary policy literature rather frustrating. It is entirely based on the premise that one can identify monetary policy shocks. First, I am not sure what is really meant by a shock. Is it any change in a policy variable? Not changing it may be a surprise, as we recently witnessed by with the recent FOMC decision not to throttle quantitative easing. And how much a change is anticipated matters as well. The recent emphasis on forward guidance makes the interpretation of an interest change very different from the surprise actions from a few years ago. Second, the empirical identification of those shocks seems doubtful at best. Either you take a VAR and interpret residuals as shocks (never mind those will be significantly different across specifications), or you try to quantify some narrative of policy decisions, sorting out rather subjectively what was a surprise and what was expected. Third, a monetary policy shock should be measured differently under different policy regimes. There is no point on focusing on the Federal funds rates (or a Taylor rule) when the policy focuses on the money supply, for example.

The reason for this rant is that I came across a paper by Martin Kliem and Alexander Kriwoluzky who try to reconcile the VAR and narrative approaches, which of course is impossible. What they highlight though is that both are fraught with error. They find this by plugging the narrative measure into a VAR and they conclude that there is measurement error in the narrative measure and misspecification error in the VAR. That should surprise no one, but needs to be pointed up, with so many people relying blindly on these instruments.

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