Forecast Error Monetary Policy Shocks

• Activity Number: 23
• Type: Topic Contributed
• Date/Time: Sunday, August 9, 2015 : 2:00 PM to 3:50 PM
• Sponsor: Business and Economic Statistics Section
• Author(s): Tara Sinclair* and Pao-Lin Tien and Edward N. Gamber
• Companies: The George Washington University and Wesleyan University and Congressional Budget Office
• Keywords: Forecast Errors ; Monetary Policy ; Shock Identification

Abstract

Much research on the impact of monetary policy on the broader economy has focused on identifying exogenous monetary policy shocks. Different approaches to addressing the inherent endogeneity of monetary policy have resulted in widely different estimates of the impact of Federal Reserve actions on the U.S. economy. This paper presents a new way of constructing monetary policy shocks by interpreting the Federal Reserve's own forecast errors as policy shocks. Making use of a forward looking Taylor rule, we first construct a measure of the impact on the federal funds rate of the Fed's errors in forecasting GDP and inflation. We then follow Romer and Romer (2004) and investigate the effect of the shock on output and price movements. On the one hand, we would hope that forecast errors would not have a large impact on the economy, particularly given their size and prevalence. On the other hand, the policy forecast error should be a high quality measure of a monetary policy shock. Our results suggest that the impact of our shock on the macroeconomy is quite small which leads us to conclude that monetary policy shocks of this type have little effect on the U.S. economy.