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The Dynamic Effects of Forward Guidance Shocks Brent Bundick & A. Lee Smith Federal Reserve Bank of Kansas City March 4, 2016 The opinions expressed herein are those of the authors and do not reflect the views of the Federal Reserve Bank of Kansas City or Federal Reserve System. Forward Guidance Shocks at the Zero Lower Bound What are the dynamic effects of forward guidance shocks on macroeconomic aggregates at the zero lower bound? ⇒ Forward guidance shocks which lower expected future policy rates increase economic activity and prices. Can a standard DSGE model generate these estimated dynamics? ⇒ Yes, a small scale New-Keynesian model can generate similar macroeconomic dynamics. ⇒ Key is to use interest rate futures contracts to discipline the size of forward guidance shocks in the model. Forward Guidance Shocks at the Zero Lower Bound What are the dynamic effects of forward guidance shocks on macroeconomic aggregates at the zero lower bound? ⇒ Forward guidance shocks which lower expected future policy rates increase economic activity and prices. Can a standard DSGE model generate these estimated dynamics? ⇒ Yes, a small scale New-Keynesian model can generate similar impulse responses. ⇒ Key is to use interest rate futures contracts to discipline the size of the forward guidance shock in the model. Our Empirical Approach We combine a high-frequency event study approach with traditional monetary VARs. ⇒ Isolate the surprise component of monetary policy from interest rate futures. ⇒ To measure the macroeconomic effects we input our high-frequency policy surprises into a monthly VAR. High-Frequency Identification Well-suited to extract forward guidance surprises. ⇒ We use a daily event window. ⇒ Implied interest-rate expectations are extracted from federal funds futures markets. ⇒ We scale the monthly policy surprises to convert them into FOMC meeting frequency surprises. VAR Model We input our high-frequency policy surprises into a monthly VAR with macroeconomic aggregates. ⇒ Sample is December 2008-December 2014. Macroeconomic Data: GDP, GDP deflator, Investment, and Capacity Utilization. Monetary Policy: The policy surprise associated with the expected federal funds rate after the 7th next FOMC meeting. ⇒ Order policy last in a recursive VAR. Empirical Responses to Forward Guidance Shock Core Capital Goods 0.15 0.6 0.3 0.1 0.4 0.05 −0.05 Percentage Points 0.4 0 0.2 0 6 12 18 24 30 −0.2 36 GDP Deflator 6 12 18 24 30 36 0.01 Annual Percentage Points 0.15 0.1 0.05 0 0 −0.01 −0.02 Impulse Response 80% Credible Set −0.05 6 12 18 24 30 36 −0.03 0.2 0.1 0 Funds Rate After 7th Meeting 0.2 Percent Capacity Utilization 0.8 Percent Percent GDP 0.2 6 12 18 24 30 36 −0.1 6 12 18 24 30 36 Forward guidance shocks which lower rates are stimulatory We have found this result to be robust to: ⇒ Using longer-dated OIS and Eurodollar interest rate futures. ⇒ Using principle components from a vector of interest-rate futures. ⇒ Using other measures of economic activity and prices. ⇒ Including the release of the minutes and the FOMC chair’s bi-annual congressional testimony in our event set. ⇒ Alternative VAR orderings. Mapping results into a DSGE Model We now estimate a small three variable VAR. ⇒ Consumption and Core PCE prices ⇒ Policy surprise is extracted from the 12-month ahead federal funds future contract. These components can be mapped into a small-scale New-Keynesian model. Mapping forward guidance shocks into a DSGE Model Consumption Price Level 0.15 0.08 0.06 Percent Percent 0.1 0.05 0 −0.05 6 12 18 24 30 36 12−Month Ahead Futures Annual Percentage Points 0.02 0 0.01 0 −0.01 −0.02 −0.03 −0.04 0.04 Impulse Response 80% Credible Set 6 12 18 24 30 36 −0.02 6 12 18 24 30 36 Can a standard business cycle generate these estimated dynamics? New-Keynesian sticky price model without capital ⇒ Shares features with models by Ireland (2003, 2010). Firms employ labor & produce ⇒ Quadratic cost of adjusting prices. Household consumes, works, & receives firm dividends ⇒ External habits in consumption. ⇒ The household’s SDF prices federal funds futures contracts. Monetary Policy d rtd = φr rt−1 + 1 − φr r + φπ Et−1 πt − π + φx Et−1 xt + νt rt = max 0, rtd νt = ρν νt−1 + σ ν ενt At ZLB: Forward guidance shock. Away from ZLB: Conventional monetary policy shock. Solution Strategy and Estimation The non-linear model is solved using the OccBin toolkit ⇒ Efficient algorithm allows for model estimation. ⇒ A good approximation to the global solution. Estimate the key model parameters using IRF matching ⇒ Minimize the distance between the data and the model counterparts following a forward guidance shock. Simulating a forward guidance shock at the ZLB: 1. Use an aggregate demand shock to drive economy to ZLB. 2. Simulate an innovation to the C.B.’s desired rate. Can a standard model generate the estimated dynamics? Price Level 0.08 0.1 0.06 0.05 0.04 Percent Percent Consumption 0.15 0 −0.05 −0.1 0 6 12 18 24 30 36 12−Month Ahead Futures Annualized Percentage Points 0.02 0 −0.02 −0.04 0.02 Empirical Impulse Response 80% Credible Set Model Impulse Response 6 12 18 24 30 36 −0.02 6 12 18 24 30 36 Conclusion We find no disconnect between empirical evidence of the dynamic effects of forward guidance shocks and a standard DSGE model. ⇒ Forward guidance shocks revealing lower expected rates at the zero lower bound are stimulatory. ⇒ A fairly standard model can generate these dynamics. Key to our approach is using interest rate futures contracts to link the forward guidance shocks in the data and the model. Additional Details Additional Model-Implied Responses Consumption Price Level 0.07 Real Interest Rate 0.06 0 0.04 Percent Percent 0.05 Annual Percentage Points 0.06 0.04 0.03 0.02 0.02 −0.05 −0.1 −0.15 0.01 6 12 18 24 30 0 36 1−Month Ahead Futures 18 24 30 −0.2 36 0.05 0 −0.05 −0.1 6 12 18 24 30 36 12 18 24 30 36 0 −0.02 −0.04 −0.06 −0.08 6 12−Month Ahead Futures 0 Annual Percentage Points Annual Percentage Points 12 6−Month Ahead Futures 0.1 −0.15 6 Annual Percentage Points 0 6 12 18 24 30 36 FG Shock Baseline Scenario −0.02 FG Shock Longer ZLB Episode Conventional MP Shock Away from ZLB −0.04 6 12 18 24 30 36 Global Solution and OccBin Solution Consumption 0.05 Price Level 0.035 2.5 Nominal Interest Rate 0.03 Annual Percentage Points 0.04 0.03 Percent Percent 0.025 0.02 0.02 0.015 0.01 0.01 2 1.5 1 0.5 0.005 12 18 24 30 0 36 1-Month Ahead Futures 0.05 0 -0.05 -0.1 6 12 18 24 30 0 36 6-Month Ahead Futures 0 -0.05 -0.1 6 12 18 24 30 36 12-Month Ahead Futures 0 Annual Percentage Points Annual Percentage Points 0.05 6 Annual Percentage Points 0 -0.025 -0.05 -0.075 Nonlinear Global Solution Piecewise Linear OccBin -0.15 6 12 18 24 30 36 -0.15 6 12 18 24 30 36 -0.1 6 12 18 24 30 36 36 Month USD OIS GDP Core Capital Goods 0.5 0.25 0.8 0.4 Percent Percent 0.6 0.15 0.1 0.4 0.2 0.05 0 0 −0.05 Percentage Points 1 0.2 6 12 18 24 30 −0.2 36 GDP Deflator 6 12 18 24 30 36 0.01 0 Annual Percentage Points 0.2 0.15 0.1 0.05 −0.01 −0.02 −0.03 0 −0.04 −0.05 −0.05 6 12 18 24 30 36 0.3 0.2 0.1 0 36−Month USD OIS 0.25 Percent Capacity Utilization 0.3 Impulse Response 80% Credible Set 6 12 18 24 30 36 −0.1 6 12 18 24 30 36 GSS Path Factor GDP Core Capital Goods Capacity Utilization 1 0.4 0.75 0.3 Percentage Points 0.15 Percent Percent 0.25 0.5 0.25 0.05 0 −0.05 6 12 18 24 30 −0.25 36 6 12 18 24 30 36 GSS Path Factor 0.025 Annual Percentage Points 0.2 Percent 0.15 0.1 0.05 0 −0.025 −0.05 0 −0.05 Impulse Response 80% Credible Set 6 12 18 24 30 36 −0.075 0.1 0 GDP Deflator 0.25 0.2 6 12 18 24 30 36 −0.1 6 12 18 24 30 36 Industrial Production Core Capital Goods 0.3 0.6 0.3 0.2 0.4 0.1 −0.1 Percentage Points 0.4 0 0.2 0 6 12 18 24 30 −0.2 36 Core PPI Finished Goods 6 12 18 24 30 36 0.01 Annual Percentage Points 0.15 0.1 0.05 0 0 −0.01 −0.02 Impulse Response 80% Confidence Interval −0.05 6 12 18 24 30 36 −0.03 0.2 0.1 0 Funds Rate After 7th Meeting 0.2 Percent Capacity Utilization 0.8 Percent Percent Industrial Production 0.4 6 12 18 24 30 36 −0.1 6 12 18 24 30 36 Expanded Event Set GDP Core Capital Goods 0.05 0.4 0.6 0.3 Percentage Points Percent Percent 0.15 Capacity Utilization 0.8 0.4 0.2 0 −0.05 6 12 18 24 30 −0.2 36 GDP Deflator Annual Percentage Points Percent 6 12 18 24 30 36 0.01 0.15 0.1 0.05 0 0 −0.01 −0.02 Impulse Response 80% Credible Set −0.05 6 12 18 24 30 36 −0.03 0.1 0 Funds Rate After 7th Meeting 0.2 0.2 6 12 18 24 30 36 −0.1 6 12 18 24 30 36 Policy Ordered First Core Capital Goods 0.15 0.6 0.3 0.1 0.4 0.05 −0.05 Percentage Points 0.4 0 0.2 0 6 12 18 24 30 −0.2 36 GDP Deflator 6 12 18 24 30 36 0.01 Annual Percentage Points 0.15 0.1 0.05 0 0 −0.01 −0.02 Impulse Response 80% Credible Set −0.05 6 12 18 24 30 36 −0.03 0.2 0.1 0 Funds Rate After 7th Meeting 0.2 Percent Capacity Utilization 0.8 Percent Percent GDP 0.2 6 12 18 24 30 36 −0.1 6 12 18 24 30 36 Forward Guidance Pre-ZLB GDP Core Capital Goods 0.5 Capacity Utilization 2 0.7 1.75 0.6 0.4 1.5 Percentage Points 0.5 1.25 Percent Percent 0.3 0.2 0.1 1 0.75 0.5 0 6 12 18 24 30 36 0 −0.25 −0.1 6 18 24 30 36 GSS Path Factor 0.05 Annual Percentage Points 0.15 Percent 12 0.075 0.2 0.1 0.05 0.025 0 −0.025 −0.05 0 −0.075 −0.05 −0.1 6 12 18 24 30 36 0.2 0 GDP Deflator 0.25 0.3 0.1 0.25 −0.1 0.4 Impulse Response 80% Credible Set 6 12 18 24 30 36 6 12 18 24 30 36 Relationship to previous work The Forward Guidance Puzzle One-Month Extension of Zero Lower Bound Duration 0.03 0.02 0.01 0 6 12 18 2 Annual Percentage Points - Level Percent Deviation From Baseline 0.035 0.04 0.03 0.025 0.02 0.015 0.01 0.005 0 24 6 12 18 Baseline Prior to FG Shock Response After FG Shock 1.5 1 0.5 0 24 Nominal Interest Rate 6 12 18 24 One-Year Extension of Zero Lower Bound Duration Price Level Consumption 6 5 4 3 2 1 0 6 12 18 24 2 Annual Percentage Points - Level 7 Percent Deviation From Baseline 7 Percent Deviation From Baseline Percent Deviation From Baseline Price Level Consumption 0.05 6 5 4 3 2 1 0 6 12 18 24 Nominal Interest Rate Baseline Prior to FG Shock Response After FG Shock 1.5 1 0.5 0 6 12 18 24 Forward Guidance Shocks & Blue Chip Forecasts Forecast Differences Levels Levels Lags of Depenedent Lags of Each Unemployment Rate Next Quarter ∆M Pt−1 −1.32∗∗∗ M Pt−1 (0.36) 0.47∗ M Pt−1 −0.45 (0.24) (0.39) M Pt−2 1.25∗∗∗ (0.35) 2 quarters ahead ∆M Pt−1 −1.09∗∗∗ M Pt−1 (0.34) 0.45∗∗ M Pt−1 −0.23 (0.19) (0.27) M Pt−2 0.95∗∗∗ (0.26) 3 quarters ahead ∆M Pt−1 −0.89∗∗∗ M Pt−1 (0.18) 0.46∗∗ M Pt−1 −0.06 (0.06) (0.22) M Pt−2 0.73∗∗∗ (0.16) 4 quarters ahead ∆M Pt−1 −0.66∗∗∗ (0.18) M Pt−1 0.48∗∗∗ M Pt−1 (0.17) 0.15 (0.22) M Pt−2 0.48∗∗∗ (0.17) Forward Guidance Shocks & Blue Chip Forecasts B.C. 4−Q Urate Forecast B.C. 4−Q GDP Deflator Forecast 0.05 0.08 0 −0.1 Percent Percentage Points 0.06 −0.05 −0.15 0.04 0.02 −0.2 0 −0.25 −0.3 6 12 18 24 30 36 GSS Path Factor 0.04 Annual Percentage Points 0.02 0 −0.02 −0.04 −0.06 −0.08 Impulse Response 80% Credible Set 6 12 18 24 30 36 −0.02 6 12 18 24 30 36 Data Policy Surprises High-Frequency Policy Surprises 0.4 7th Next FOMC Meeting GSS Path Factor 36 Month USD OIS 0.4 0.2 0.2 -0.0 -0.0 -0.2 -0.2 -0.4 -0.4 -0.6 -0.6 -0.8 -0.8 2009 2010 2011 2012 2013 2014