Did the Fed Act Gradually? Estimating Changes in Inflation Pressure in Real Time Pierre L. Siklos, WLU Diana N. Weymark, Vanderbilt

Motivation

Focus

Vintages Examined so far August 1998 May 2002 November 2002 May 2004 Full sample: 1970-end of vintage Sub-sample: end of vintage

What is Inflation Pressure? I

What is Inflation Pressure? II

The Ups and Downs of the fed funds rate The period is especially interesting because of the ‘conundrum’ (rotating yield curve; Backus and Wright 2007) Inflation was also generally held in check Other episodes? Jan June 2003 easing: 70% of reductions were 5obp at a time. June 1989 – Sept 1992: 25bp cuts 90% of the time , , tightening usually involved 25bp rises, with 50bp increases infrequent

Target Fed funds rate I

Target Fed funds rate: II

Measuring the Impact of Monetary Policy

Introducing Measures of Inflation Pressure BUT….

Counterfactual Experiments are Needed

Methodology: Outline

The Model for the US Economy

Solving the Model Conjecture a solution & solve using TR

Solving the Model: I

Solving the Model: II

Solving the Model: III

Solving the Model: EAIP

Ex Post IP (EPIP): I

EPIP: II

Indicators of Monetary Policy: I PIIP t =0  No change in IP =1  Inflation held constant <0  MP underreacts to IP (actually raises it) > 1  MP ‘overshoots’* *opposite sign 0<PIIP<1  MP reduces some IP

Indicators of Monetary Policy: II MPE t =1  MP completely effective =0  MP ineffective or ‘neutral’ <0  MP unsuccessful IP maginfied > 1  MP ‘overshoots’* *opposite sign 0<MPE<1  MP partially effective

Measuring IP with Quarterly Data There is a ‘control’ lag between the interest rate and inflation Therefore IP is the inflation observed at time t if the interest rate at time t-1 (or t, t-2, depending on the lag structure) had been held constant at its t-2 level Interest rates in other periods generated by the policy maker’s TR IP captures the impact on inflation of a one-period deviation from the TR

US Real Time Data Federal Reserve Bank of Philadelphia Real- Time Data Set Interest rates and consumer prices are from the Federal Reserve Bank of St. Louis’ FRED II The real interest rate: Greenbook, SPF, UMich survey, Economist, Consensus Output Gap: H-P filter & CBO estimates

Inflation Rates

Real Interest Rates

Output gap: final revised

Illustration of Model Estimates

Ex Ante IP: I

Ex Ante IP: II

PIIP: Post 1980 Sample

MPE: Post 1980 sample

Conclusions The Fed may have acted gradually simply because it was largely successful in influencing expectations of future inflation The Fed was not always conducting a successful monetary policy November 2002: MP was clearly unsuccessful since inflationary pressure ex post was higher than ex ante Nevertheless, a sharp turnaround took place by the time of the May 2004 vintage The biggest impact on monetary policy performance occurs not because the Fed changes its policy rate but via the changes in inflationary expectations these changes promote Our results not only reinforce the dramatic revisions in our assessment of the conduct of monetary policy based on real time data Models that evaluate policies based on data that stretch back before 1980 must allow for the fact that a notable structural shift