Expectations, Learning and Monetary Policy: An Overview of Recent Research

Expectations about the future are central for determination of current macroeconomic outcomes and the formulation of monetary policy. Recent literature has explored ways for supplementing the benchmark of rational expectations with explicit models of expectations formation that rely on econometric learning. Some apparently natural policy rules turn out to imply expectational instability of private agents’ learning. We use the standard New Keynesian model to illustrate this problem and survey the key results about interest-rate rules that deliver both uniqueness and stability of equilibrium under econometric learning. We then consider some practical concerns such as measurement errors in private expectations, observability of variables and learning of structural parameters required for policy. We also discuss some recent applications including policy design under perpetual learning, estimated models with learning, recurrent hyperinflations, and macroeconomic policy to combat liquidity traps and deflation.

Common and Idiosyncratic Factors of the Exchange Risk Premium in Emerging European Markets

Existing empirical evidence suggests that the Uncovered Interest Rate Parity (UIRP) condition may not hold due to an exchange risk premium. For a panel data set of eleven emerging European economies we decompose this exchange risk premium into an idiosyncratic (country-specific) elements and a common factor using a principal components approach. We present evidence of a stationary idiosyncratic component and nonstationary common factor. This result leads to the conclusion of a nonstationary risk premium for these countries and a violation of the UIRP in the long-run, which is in contrast to previous studies often documenting a stationary premium in developed countries. Furthermore, we report that the variation in the premium is largely attributable to a common factor influenced by economic developments in the United States.

Dynamic Option Adjusted Spread and the Value of Mortgage Backed Securities (Draft 2)

We extend a reduced form model for pricing pass-through mortgage backed securities (MBS) and provide a novel hedging tool for investors in this market. To calculate the price of an MBS, traders use what is known as option-adjusted spread (OAS). The resulting OAS value represents the required basis points adjustment to reference curve discounting rates needed to match an observed market price. The OAS suffers from some drawbacks. For example, it remains constant until the maturity of the bond (thirty years in mortgage-backed securities), and does not incorporate interest rate volatility. We suggest instead what we call dynamic option adjusted spread (DOAS), which allows investors in the mortgage market to account for both prepayment risk and changes of the yield curve.

The Taylor Principle and (In-) Determinacy in a New Keynesian Model with hiring Frictions and Skill Loss

We introduce duration dependent skill decay among the unemployed into a New-Keynesian model with hiring frictions developed by Blanchard/Gali (2008). If the central bank responds only to (current, lagged or expected future) inflation and quarterly skill decay is above a threshold level, determinacy requires a coefficient on inflation smaller than one. The threshold level is plausible with little steady-state hiring and firing ("Continental European Calibration") but implausibly high in the opposite case ("American calibration"). Neither interest rate smoothing nor responding to the output gap helps to restore determinacy if skill decay exceeds the threshold level. However, a modest response to unemployment guarantees determinacy. Moreover, under indeterminacy, both an adverse sunspot shock and an adverse technology shock increase unemployment extremely persistently.

A Bootstrap Neural Network Based Heterogeneous Panel Unit Root Test: Application to Exchange Rates

This paper proposes a bootstrap artificial neural network based panel unit root test in a dynamic heterogeneous panel context. An application to a panel of bilateral real exchange rate series with the US Dollar from the 20 major OECD countries is provided to investigate the Purchase Power Parity (PPP). The combination of neural network and bootstrapping significantly changes the findings of the economic study in favour of PPP.

Transmission of macro-liquidity shocks to liquidity-sorted stock portfolios’ returns: The role of the financial crisis

This study examines the impact of macro-liquidity shocks on the returns of UK stock portfolios sorted on the basis of a series of micro-liquidity measures. The macro-liquidity shocks are extracted on the meeting days of the Bank of England Monetary Policy Committee relative to market expectations embedded in futures contracts on the 3-month LIBOR during the period June 1999- December 2009. We report definitive evidence that these shocks are transmitted to the cross-section of liquidity-sorted portfolios, with most liquid stocks playing a very active role. Our results emphatically document that the shocks-returns relationship has reversed its sign during the recent financial crisis; the standard inverse relationship between interest rate surprises and portfolios’ returns before the crisis has turned into positive during the crisis. This finding confirms the inability of interest rate cuts to boost returns in the shortrun during the crisis, because these were perceived by market participants as a signal of a deteriorating economic outlook.

Time Horizons And Smoothing In The Bank Of England’s Reaction Function: The Contrast Between The Standard GMM And Ex Ante Forecast Approaches

The monetary policy reaction function of the Bank of England is estimated by the standard GMM approach and the ex-ante forecast method developed by Goodhart (2005), with particular attention to the horizons for inflation and output at which each approach gives the best fit. The horizons for the ex-ante approach are much closer to what is implied by the Bank’s view of the transmission mechanism, while the GMM approach produces an implausibly slow adjustment of the interest rate, and suffers from a weak instruments problem. These findings suggest a strong preference for the ex-ante approach.

Time Horizons And Smoothing In The Bank Of England’s Reaction Function: The Contrast Between The Standard GMM And Ex Ante Forecast Approaches

The monetary policy reaction function of the Bank of England is estimated by the standard GMM approach and the ex-ante forecast method developed by Goodhart (2005), with particular attention to the horizons for inflation and output at which each approach gives the best fit. The horizons for the ex-ante approach are much closer to what is implied by the Bank’s view of the transmission mechanism, while the GMM approach produces an implausibly slow adjustment of the interest rate, and suffers from a weak instruments problem. These findings suggest a strong preference for the ex-ante approach.

How Optimal is US Monetary Policy?

Most of the literature estimating DSGE models for monetary policy analysis assume that policy follows a simple rule. In this paper we allow policy to be described by various forms of optimal policy - commitment, discretion and quasi-commitment. We find that, even after allowing for Markov switching in shock variances, the inflation target and/or rule parameters, the data preferred description of policy is that the US Fed operates under discretion with a marked increase in conservatism after the 1970s. Parameter estimates are similar to those obtained under simple rules, except that the degree of habits is significantly lower and the prevalence of cost-push shocks greater. Moreover, we find that the greatest welfare gains from the ‘Great Moderation’ arose from the reduction in the variances in shocks hitting the economy, rather than increased inflation aversion. However, much of the high inflation of the 1970s could have been avoided had policy makers been able to commit, even without adopting stronger anti-inflation objectives. More recently the Fed appears to have temporarily relaxed policy following the 1987 stock market crash, and has lost, without regaining, its post-Volcker conservatism following the bursting of the dot-com bubble in 2000.

Monetary Policy Delegation and Equilibrium Coordination

This paper revisits the argument that the stabilisation bias that arises under discretionary monetary policy can be reduced if policy is delegated to a policymaker with redesigned objectives. We study four delegation schemes: price level targeting, interest rate smoothing, speed limits and straight conservatism. These can all increase social welfare in models with a unique discretionary equilibrium. We investigate how these schemes perform in a model with capital accumulation where uniqueness does not necessarily apply. We discuss how multiplicity arises and demonstrate that no delegation scheme is able to eliminate all potential bad equilibria. Price level targeting has two interesting features. It can create a new equilibrium that is welfare dominated, but it can also alter equilibrium stability properties and make coordination on the best equilibrium more likely.

Stock Market Liquidity and Macro-Liquidity Shocks: Evidence from the 2007-2009 Financial Crisis

We develop an empirical framework that links micro-liquidity, macro-liquidity and stock prices. We provide evidence of a strong link between macro-liquidity shocks and the returns of UK stock portfolios constructed on the basis of micro-liquidity measures between 1999-2012. Specifically, macro-liquidity shocks, which are extracted on the meeting days of the Bank of England Monetary Policy Committee relative to market expectations embedded in 3-month LIBOR futures prices, are transmitted in a differential manner to the cross-section of liquidity-sorted portfolios, with liquid stocks playing the most active role. We also find that there is a significant increase in shares’ trading activity and a rather small increase in their trading cost on MPC meeting days. Finally, our results emphatically document that during the recent financial crisis the shocks-returns relationship has reversed its sign. Interest rate cuts during the crisis were perceived by market participants as a signal of deteriorating economic prospects and reinforced “flight to safety” trading.

An Empirical Assessment of Optimal Monetary Policy Delegation in the Euro Area

We estimate a New Keynesian DSGE model for the Euro area under alternative descriptions of monetary policy (discretion, commitment or a simple rule) after allowing for Markov switching in policy maker preferences and shock volatilities. This reveals that there have been several changes in Euro area policy making, with a strengthening of the anti-inflation stance in the early years of the ERM, which was then lost around the time of German reunification and only recovered following the turnoil in the ERM in 1992. The ECB does not appear to have been as conservative as aggregate Euro-area policy was under Bundesbank leadership, and its response to the financial crisis has been muted. The estimates also suggest that the most appropriate description of policy is that of discretion, with no evidence of commitment in the Euro-area. As a result although both ‘good luck’ and ‘good policy’ played a role in the moderation of inflation and output volatility in the Euro-area, the welfare gains would have been substantially higher had policy makers been able to commit. We consider a range of delegation schemes as devices to improve upon the discretionary outcome, and conclude that price level targeting would have achieved welfare levels close to those attained under commitment, even after accounting for the existence of the Zero Lower Bound on nominal interest rates.

An Empirical Assessment of Optimal Monetary Policy Delegation in the Euro Area

We estimate a New Keynesian DSGE model for the Euro area under alternative descriptions of monetary policy (discretion, commitment or a simple rule) after allowing for Markov switching in policy maker preferences and shock volatilities. This reveals that there have been several changes in Euro area policy making, with a strengthening of the anti-inflation stance in the early years of the ERM, which was then lost around the time of German reunification and only recovered following the turnoil in the ERM in 1992. The ECB does not appear to have been as conservative as aggregate Euro-area policy was under Bundesbank leadership, and its response to the financial crisis has been muted. The estimates also suggest that the most appropriate description of policy is that of discretion, with no evidence of commitment in the Euro-area. As a result although both ‘good luck’ and ‘good policy’ played a role in the moderation of inflation and output volatility in the Euro-area, the welfare gains would have been substantially higher had policy makers been able to commit. We consider a range of delegation schemes as devices to improve upon the discretionary outcome, and conclude that price level targeting would have achieved welfare levels close to those attained under commitment, even after accounting for the existence of the Zero Lower Bound on nominal interest rates.

US Monetary and Fiscal Policies - Conflict or Cooperation?

Most of the literature estimating DSGE models for monetary policy analysis ignores fiscal policy and assumes that monetary policy follows a simple rule. In this paper we allow both fiscal and monetary policy to be described by rules and/or optimal policy which are subject to switches over time. We find that US monetary and fiscal policy have often been in conflict, and that it is relatively rare that we observe the benign policy combination of an conservative monetary policy paired with a debt stabilizing fiscal policy. In a series of counterfactuals, a conservative central bank following a time-consistent fiscal policy leader would come close to mimicking the cooperative Ramsey policy. However, if policy makers cannot credibly commit to such a regime, monetary accommodation of the prevailing fiscal regime may actually be welfare improving.

Growth Rate Estimation in the presence of Unit Roots

This study addresses the issue of the presence of a unit root on the growth rate estimation by the least-squares approach. We argue that when the log of a variable contains a unit root, i.e., it is not stationary then the growth rate estimate from the log-linear trend model is not a valid representation of the actual growth of the series. In fact, under such a situation, we show that the growth of the series is the cumulative impact of a stochastic process. As such the growth estimate from such a model is just a spurious representation of the actual growth of the series, which we refer to as a “pseudo growth rate”. Hence such an estimate should be interpreted with caution. On the other hand, we highlight that the statistical representation of a series as containing a unit root is not easy to separate from an alternative description which represents the series as fundamentally deterministic (no unit root) but containing a structural break. In search of a way around this, our study presents a survey of both the theoretical and empirical literature on unit root tests that takes into account possible structural breaks. We show that when a series is trendstationary with breaks, it is possible to use the log-linear trend model to obtain well defined estimates of growth rates for sub-periods which are valid representations of the actual growth of the series. Finally, to highlight the above issues, we carry out an empirical application whereby we estimate meaningful growth rates of real wages per worker for 51 industries from the organised manufacturing sector in India for the period 1973-2003, which are not only unbiased but also asymptotically efficient. We use these growth rate estimates to highlight the evolving inter-industry wage structure in India.