Jon Faust

When do long-run identifying restrictions give reliable results?

Many recent articles have identified behavioral disturbances in vector autoregressions by imposing restrictions on the long-run effects of shocks. This article demonstrates that this approach will be unreliable unless the underlying economy satisfies three types of strong restrictions. Although many aspects of these issues have been raised before, this article draws out and illustrates the implications for inferences under the long-run scheme. Furthermore, it provides strategies for dealing with the problems.

The Robustness of Identified VAR Conclusions About Money

This paper presents a new way to assess robustness of claims from identified VAR work. All possible identifications are checked for the one that is worst for the claim, subject to the restriction that the VAR produce reasonable impulse responses to shocks. The statistic on which the claim is based need not be identified; thus, one can assess claims in large models using minimal restrictions. The technique reveals only weak support for the claim that monetary policy shocks contribute a small portion of the forecast error variance of post-War U.S. output in standard 6-variable and 13-variable models.

News and Noise in G-7 GDP Announcements

Revisions to GDP announcements are known to be quite large in all G-7 countries: many revisions in quarterly GDP growth are over a full percentage point at an annualized rate. In this paper, we examine the predictability of these data revisions. Previous work suggests that U.S. GDP revisions are largely unpredictable, as would be the case if the revisions reflect news not available at the time that the preliminary number is produced. We find that the degree of predictability varies throughout the G-7. For the U.S., the revisions are very slightly predictable, but for Italy, Japan and the UK, about half the variability of subsequent revisions can be accounted for by information available at the time of the preliminary announcement. For these countries, it appears that revisions reflect, to a significant degree, the removal of noise from the preliminary numbers, rather than the arrival of news.

Identifying VARs Based on High Frequency Futures Data

Using the prices of federal funds futures contracts, we measure the impact of the surprise component of Federal Reserve policy decisions on the expected future trajectory of interest rates. We show how this information can be used to identify the effects of a monetary policy shock in a standard monetary policy VAR. This constitutes an alternative approach to identification that is quite different, and, we would argue, more plausible, than the conventional short-run restrictions. We find that the usual recursive identification of the model is rejected, but we nevertheless agree with the literatures conclusion that only a small fraction of the variance of output can be attributed to monetary policy shocks.

The Equilibrium Degree of Transparency and Control in Monetary Policy

We examine a central banks endogenous choice of degree of control and degree of transparency, under both commitment and discretion. We argue that discretion is the more realistic assumption for the choice of control and that commitment is more realistic for the choice of transparency. For the choice of control, under discretion maximum degree of control is the only equilibrium. For the choice of transparency, under commitment, a sufficiently patient bank with sufficiently low average inflation bias will always choose minimum transparency. Thus, a maximum feasible degree of control with a minimum degree of transparency is a likely outcome. The Bundesbank and the Federal Reserve System are, arguably, examples of this.

Breaks in the Variability and Co-Movement of G-7 Economic Growth

This paper investigates breaks in the variability and co-movement of output, consumption, and investment in the G-7 economies. In contrast with most other papers on co-movement, we test for changes in co-movement allowing for breaks in mean and variance. Despite claims that rising integration among these economies has increased output correlations among them, we find no clear evidence of an increase in correlation of growth rates of output, consumption, or investment. This finding is true even for the United States and Canada, which have seen a tremendous increase in bilateral trade shares, and for the members of the euro area in the G-7.

Comparing Greenbook and Reduced Form Forecasts Using a Large Realtime Dataset

Many recent articles have found that atheoretical forecasting methods using many predictors give better predictions for key macroeconomic variables than various small-model methods. The practical relevance of these results is open to question, however, because these articles generally use ex post revised data not available to forecasters and because no comparison is made to best actual practice. We provide some evidence on both of these points using a new large dataset of vintage data synchronized with the Fed’s Greenbook forecast. This dataset consist of a large number of variables as observed at the time of each Greenbook forecast since 1979. We compare realtime, large dataset predictions to both simple univariate methods and to the Greenbook forecast. For inflation we find that univariate methods are dominated by the best atheoretical large dataset methods and that these, in turn, are dominated by Greenbook. For GDP growth, in contrast, we find that once one takes account of Greenbook’s advantage in evaluating the current state of the economy, neither large dataset methods, nor the Greenbook process offers much advantage over a univariate autoregressive forecast.

An Empirical Comparison of Bundesbank and ECB Monetary Policy Rules

We estimate a monetary policy reaction function for the Bundesbank and use it as a benchmark to assess the monetary policy of the ECB since the launch of the euro in January 1999. We find that euro interest rates are low relative to this benchmark. We consider several possible reasons for this, including the divergence between core and headline inflation, inflation having turned out to be higher than could have been foreseen by the ECB and the possibility that the ECB is focussing only on macroeconomic conditions in a subset of member countries. We argue that these potential explanations cannot account for the difference between recent interest rates and our estimated Bundesbank benchmark. Our results suggest that the reaction function of the ECB features a high weight on the output gap relative to the weight on inflation, compared to the Bundesbank.

Money, Politics and the Post-War Business Cycle

While macroeconometricians continue to dispute the size, timing, and even the existence of effects of monetary policy, political economists often find large effects of political variables and often attribute the effects to manipulation of the Fed. Since the political econometricians often use smaller information sets and less elaborate approaches to identification than do macroeconometricians, their striking results could be the result of simultaneity and omitted variable biases. Alternatively, political whims may provide the instrument for exogenous policy changes that has been the Grail of the policy identification literature. In this paper, we lay out and apply a framework for distinguishing these possibilities. We find almost no support for the hypothesis that political effects on the macroeconomy operate through monetary policy and only weak evidence that political effects are significant at all.

Is Inflation Targeting Best-Practice Monetary Policy?

We describe the inflation targeting framework (ITF) and compare it against hypothetical best-practice based on optimization. The core requirements of the ITF are an explicit long-run inflation goal and a commitment to transparency in policymaking. Advocates and practitioners of the ITF have made many contributions to clear goal setting and communication by central banks. However, we contend that ITF communication policies both as advocated and practiced often have some elements that either obfuscate or, in some cases, explicitly contradict the dictates of optimization in a stabilization-policy paradigm. In this paradigm, the central bank has an objective function that places weight on both inflation and output-gap stabilization and faces a conventional (exploitable) Phillips-curve trade-off. We point out some problems that the ITF communication policy may generate in this setting. Our analysis leads us to make four suggestions for communication policy intended to help central banks avoid these problems.