Did the Fed Act Gradually? Estimating Changes in

Inflation Pressure in Real Time

Pierre L. Siklos, WLUDiana 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: 1980- end of vintage

What is Inflation Pressure? I

What is Inflation Pressure? II

The Ups and Downs of the fed funds rate

The 2004-2005 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 2001- June 2003 easing: 70% of reductions were

5obp at a time. June 1989 – Sept 1992: 25bp cuts 90% of the time 1994-95, 1999-2000, 2004-06 tightening usually

involved 25bp rises, with 50bp increases infrequent

Target Fed funds rate I

0

2

4

6

8

10

121/1

/1983

1/1

/1984

1/1

/1985

1/1

/1986

1/1

/1987

1/1

/1988

1/1

/1989

1/1

/1990

1/1

/1991

1/1

/1992

1/1

/1993

1/1

/1994

1/1

/1995

1/1

/1996

1/1

/1997

1/1

/1998

1/1

/1999

1/1

/2000

1/1

/2001

1/1

/2002

1/1

/2003

1/1

/2004

1/1

/2005

1/1

/2006

1/1

/2007

Per

cent

Target Fed funds rate: II

0

1

2

3

4

5

6

7

Per

cent

Measuring the Impact of Monetary Policy

Measuring the Impact of Monetary Policy

Introducing Measures of Inflation Pressure

BUT….

Counterfactual Experiments are Needed

Methodology: Outline

The Model for the US Economy

1 1 2 1[ ]t t t t t t ty i E E y u

tttttt ey~E 31211

0 1 (1 )[ ]

, 0

t t t t m y t t n ti i E E y

m n

Solving the Model

Conjecture a solution & solve using TR

1 2 3 1t t t ty u e i

1321 tttt ieu

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 PIIPt

=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

0

1ti

t t tt

t t

PIIPEAIP EAIP

Indicators of Monetary Policy: II MPEt

=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

1 tt

t

EPIPMPE

EAIP

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

0

2

4

6

8

10

12

14

1970 1975 1980 1985 1990 1995 2000 2005

CPI Pers Cons Exp Implicit Price deflator

Per

cent

Real Interest Rates

-4

0

4

8

12

16

1970 1975 1980 1985 1990 1995 2000 2005

Greenbook University of MichiganSPF ConsensusAverage one year ahead inflation

Per

cent

Output gap: final revised

-.10

-.08

-.06

-.04

-.02

.00

.02

.04

1970 1975 1980 1985 1990 1995 2000

H-P filter CBO estimates

Illustration of Model Estimates

Ex Ante IP: I

0

4

8

12

16

20

24

1970 1975 1980 1985 1990 1995 2000 2005

1998 08 1998 08 2004 052002 11 2002 05

Ex

ante

Lev

el o

f In

flat

ion

Ex Ante IP: II

0

4

8

12

16

20

24

1980 1985 1990 1995

Ex ante inflation Pressure: full sampleActual inflationEx ante inflation Pressure: sub sample

Per

cent

PIIP: Post 1980 Sample

-.05

.00

.05

.10

.15

.20

.25

.30

.35

80 82 84 86 88 90 92 94 96 98

May 2002 May 2004August 1998 November 2002

Pol

icy In

duce

d In

flat

ion Pre

ssur

e

MPE: Post 1980 sample

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1970 1975 1980 1985 1990 1995 2000 2005

08 1998 11 2002 08 199805 2004 05 2002

Mon

etar

y Pol

icy Effec

tive

ness

Ind

icat

or

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