Monetary policy shocks

What exactly are Monetary policy shocks and why are they important ? 

The investigation of the complex relationship between monetary policy and its wider economic impacts has been a long-standing topic in academic research. However, research in this area, which typically uses vector auto-regressive (VAR) models, has often encountered compelling puzzles when attempting to trace the impact of monetary policy actions on real-world variables. 

Many of these models reproduce --especially before the 2008 crisis-- a "price puzzle”, a rise in price levels following an increase in monetary policy (Christiano, 1992; Hanson, 2004). As it is often the case that monetary policy actions respond to changes in price levels, the empirical method have struggled to separate the endogenous and exogenous effects.  

Romer and Romer (2004) introduced the narrative approach as a robust and reliable instrument in identifying US monetary policy shocks, by isolating exogenous changes in the Fed's monetary policy through the analysis of FOMC minutes. However, the seminal work of Kuttner (2001) and Cochrane (2002), which identify "high-frequency monetary policy shocks" based on changes in futures rates to gauge policy expectations around central bank policy announcements, have become the accepted standard in empirical monetary economics (Gertler, 2015). 

However, there are sizeable differences in the construction of high-frequency monetary policy shocks. One of the most fundamental differences in shocks lies in the choice of the indicator used for the identification of the surprises, ranging from fourth federal funds futures contract (FF4) (Romer, 2004; Gertler, 2015; Jarocinski, 2020, Miranda-Agrippino, 2021), to the first principal component of changes in short-term interest rates up to 2 years (Nakamura, 2018; Barakchian, 2013) or the choice of the whole US yield curve (Bu, 2021). 

The low-for-long monetary policy era that emerged following the 2007 global crisis gave rise to a new literature on forward guidance, commitment and unconventional monetary policy tools (Campbell, 2012). Thus, further debate has emerged on the identification of unconventional monetary policy shocks, distinguishing from "Odyssean” forward guidance --a commitment to a future path of monetary policy-- and a "Delphic” forward guidance -- a declaration concerning the forthcoming trajectory of policy rates based on the expected path of monetary policy  (Andrade, 2021; Jarocinski, 2021).

The latest developments concerning the identification of monetary policy shocks revolve around the impact of information asymmetries (Melosi, 2017). Indeed, market-based monetary surprises assume perfect information for private agents  (Gertler, 2015) while narrative methods assume a set of perfect information for central banks (Romer, 2004). This asymmetry can give rise to puzzling effects, such as the co-movement of interest rates and stock prices around policy announcements --for instance, a surprise tightening arising from an over-performance of the economy can boost stock prices--  (Jarocinski, 2020). In order to disentangle the "information effect" from the pure recessionary shock, Miranda-Agrippino (2021) construct an instrument that directly controls for the signalling channel of monetary policy. This instrument is computed by regressing the high frequency surprises of the fourth federal fund future indicator (FF4) on the Greenbok macroeconomic forecasts released with a five year delay to the general public, employed by Romer (2004). Miranda-Agrippino (2021) define truly exogenous monetary policy shocks as :

"Exogenous shifts in the policy instrument that surprise market participants, are unforecastable, and are not due to the central bank’s systematic response to its own assessment of the macroeconomic outlook."

Below you will be able to find a comparison of the most relevant US monetary policy shocks and the links :