We provide evidence on the nature of the monetary transmission mechanism. To identify policy shocks in a setting with both economic and financial variables, we combine traditional monetary vector autoregression (VAR) analysis with high frequency identification (HFI) of monetary policy shocks. We first show that the shocks identified using HFI surprises as external instruments produce responses in output and inflation consistent with both textbook theory and conventional monetary VAR analysis. We also find, however, that monetary policy surprises typically produce "modest movements" in short rates that lead to "large" movements in credit costs and economic activity. The large movements in credit costs are mainly due to the reaction of both term premia and credit spreads that are typically absent from the standard model of monetary policy transmission. Finally, we show that forward guidance is important to the overall strength of the transmission mechanism.
Central bank announcements simultaneously convey information about monetary policy and the central bank's assessment of the economic outlook. This paper disentangles these two components and studies their effect on the economy using a structural vector autoregression. It relies on the information inherent in high-frequency co-movement of interest rates and stock prices around policy announcements: a surprise policy tightening raises interest rates and reduces stock prices, while the complementary positive central bank information shock raises both. These two shocks have intuitive and very different effects on the economy. Ignoring the central bank information shocks biases the inference on monetary policy nonneutrality. (JEL D83, E43, E44, E52, E58, G14)
T his paper provides evidence on the nature of the monetary policy transmission mechanism. We focus in particular on how monetary policy actions influence credit costs that in turn affect economic activity. Our goal is to assess the extent to which the response of credit costs to monetary policy is consistent with standard theory and, in doing so, identify any significant discrepancies that the theory should address.There is of course a voluminous literature on monetary policy transmission. 1 Two main considerations motivate us to revisit this classic topic. First, the conventional models of monetary policy transmission treat financial markets as frictionless. To put it mildly, the recent financial crisis suggests rethinking this premise. As we discuss in Section I, the conventional "frictionless" frameworks have sharp predictions for how credit costs should respond to monetary policy actions. In particular, the response of borrowing rates should depend entirely on the expected path of the central bank's policy instrument, the short-term interest rate. To a first approximation there should be no response in either term premia or credit spreads. We proceed to examine this hypothesis. The goal here is to determine whether a significant component of the response of credit costs to monetary policy may indeed reflect movements in term premia and credit spreads, consistent with some form of financial market imperfection.1 See Boivin et al. (2010) for a recent survey.
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