Monetary Policy, Real Activity, and Credit Spreads: Evidence from Bayesian Proxy SVARs

Abstract

In this paper, we develop a Bayesian framework to estimate a proxy structural vector autoregression to identify monetary policy shocks. We find that during the Great Moderation period, monetary policy shocks induce a persistent decline in real activity and tightening in financial conditions. Central to this result is a systematic component of monetary policy characterized by a direct and economically significant reaction to changes in corporate credit spreads. The failure to account for this endogenous reaction induces an attenuation in the response of all variables to monetary shocks, a result that also applies to the narrative identification of Romer and Romer (2004). (JEL C32, E23, E32, E44, E52, E58)

Decomposing the effects of monetary policy using an external instruments SVAR

“…The excess bond premium of Gilchrist and Zakrajsek (2012) is an easy way to capture some of this missing information in the SVAR. This has been advocated in recent papers by GK and Caldara and Herbst (2019). We re-estimate the SVAR adding the excess bond premium as a fifth variable.…”

The response of asset prices to monetary policy shocks: Stronger than thought

“…Conventional vector autoregressions (VARs), on the other hand, often find rather sluggish or even insignificant asset price reactions, especially when employing a recursive identification approach; see, for example, Eichenbaum and Evans (1995) and Grilli and Roubini (1996) for exchange rates; Beckworth, Moon, and Toles (2012) for corporate bond spreads; Li, Iscan, and Xu (2010) and Galí and Gambetti (2015) for stock prices; and Iacoviello (2005), Goodhart and Hofmann (2008), and Calza, Monacelli, and Stracca (2013) for house prices. 1 Two approaches have proven useful to resolve these puzzles: External instruments avoid controversial assumptions about the contemporaneous effect of shocks, and factor models significantly enlarge the information set compared to standard VARs; see Gertler and Karadi (2015) and Caldara and Herbst (2019) for the former; and Gambetti (2010), Del Negro andOtrok (2007), Luciani (2015), and Kerssenfischer (2019b) for the latter. In this paper, we employ both approaches jointly to study the effects of monetary policy shocks for two regions, namely the euro area and the USA.…”

“…While event study evidence is usually consistent with this prediction, conventional VARs often find sluggish responses of asset prices.10 Note that house prices are interpolated as they are only available at a quarterly frequency. 11 This is in contrast toCaldara and Herbst (2019), who find that the inclusion of corporate credit spreads resolves puzzling VAR results. 12 Note that 2-year sovereign yields, as well as short-term money market rates (see Supporting Information Appendix), revert back to normal only slowly in VARs, but quickly in factor models.…”

Yield Curve and Financial Uncertainty: Evidence Based on US Data

“…Our findings are consistent with the ‘risk‐management hypothesis’ put forth by Greenspan (), that is, the impact of (different forms of) uncertainty on US monetary policy decision making. Taylor‐rule based investigations considering proxies for risk have been proposed by Castelnuovo (), Castelnuovo (), Evans et al (), Caggiano, Castelnuovo and Nodari (), Caldara and Herbst (), and Ponomareva, Sheen and Wang (); quantile‐regression frameworks linking policy rates to risk have been estimated by Giglio, Kelly, and Pruitt (); nonlinear VARs connecting uncertainty shocks and policy rates have been estimated by Caggiano, Castelnuovo and Nodari (). Our paper confirms, with a different empirical strategy such as local projections, that the response of the short end of the term structure is indeed consistent with the risk‐management hypothesis postulated by Greenspan ().…”