Kenneth N. Kuttner

What Explains the Stock Market's Reaction to Federal Reserve Policy?

This paper analyzes the impact of unanticipated changes in the federal funds rate target on equity prices, with the aim of both estimating the size of the typical reaction and understanding the reasons for the markets response. We find that over the June 1989-December 2002 sample period, a typical unanticipated rate cut of 25 basis points is associated with an increase of roughly 1 percent in the level of stock prices, as measured by the CRSP value-weighted index. There is some evidence of a stronger stock price response to changes in rates that are expected to be more permanent or that represent a reversal in the direction of rate changes. The estimated response of stock prices to fund rate surprises varies widely across industries, but in a manner consistent with the predictions of the standard capital asset pricing model. Applying the methods of Campbell (1991) and Campbell and Ammer (1993), we find that most of the effect of monetary policy on stock prices can be traced to its implications for forecasted equity risk premiums. Some effect can be traced to the implications of monetary policy surprises for forecasted dividends, but very little stems from the impact of policy on expectations of the real rate of interest.

Estimating Potential Output as a Latent Variable

This article proposes a new method for estimating potential output in which potential real gross domestic product (GDP) is modeled as an unobserved stochastic trend, and deviations of GDP from potential affect inflation through an aggregate supply relationship. The output and inflation equations together form a bivariate unobserved-components model which is estimated via maximum likelihood through the use of the Kalman-filter algorithm. The procedure yields a measure of potential output and its standard error and an estimate of the quantitative response of inflation to real growth and the output gap.

Does Talk Matter After All?: Inflation Targeting and Central Bank Behavior

Since 1990, a number of countries have adopted inflation targeting as their declared monetary strategy. Interpretations of the significance of this movement, however, have differed widely. To some, inflation targeting mandates the single-minded, rule-like pursuit of price stability without regard for other policy objectives; to others, inflation targeting represents nothing more than the latest version of cheap talk by central banks unable to sustain monetary commitments. Advocates of inflation targeting, including the adopting central banks themselves, have expressed the view that the transparency and communication of the inflation targeting framework grant the central bank greater short-run flexibility in pursuit of its long-run inflation goal.

Another look at the evidence on money-income causality

Abstract Stock and Watsons widely noted finding that money has statistically significant marginal predictive power with respect to real output (as measured by industrial production), even in a sample extending through 1985 and even in the presence of a short-term interest rate, is not robust to two plausible changes. First, extending the sample through 1990 renders money insignificant within Stock and Watsons chosen specification. Second, using the commercial paper rate in place of the Treasury bill rate renders money insignificant even in the sample ending in 1985. A positive finding is that the difference between the commercial paper rate and the Treasury bill rate does have highly significant predictive value for real output, even in the presence of money, regardless of sample. Alternative results, based on forecast error variance decomposition in a vector autoregression setting, confirm these findings by indicating a small and generally insignificant effect of money and a large and highly significant effect of the paper-bill spread on real output.

Fiscal Policy Effectiveness in Japan

The effectiveness of fiscal policy in Japan over the past decade has been a matter of great controversy. We investigate the effectiveness of Japanese fiscal policy over the 1976-1999 period using a structural VAR analysis of real GDP, tax revenues, and public expenditures. We find that expansionary fiscal policy, whether in the form of tax cuts or of public works spending, had significant stimulative effects. Using a new method of computing policy multipliers from structural VARs, we calculate that the multiplier on tax cuts is about 25% higher at a four-year horizon than that on public works spending, though both are well in excess of one. A historical decomposition reveals that Japanese fiscal policy was contractionary over much of the 1990s, and a significant proportion of the variation in growth can be attributed to fiscal policy shocks; accordingly, most of the run-up in public debt is attributable to declining tax revenues due to the recession. Examining savings behavior directly, we find limited evidence of Ricardian effects, insufficient to offset the short-term effects of discretionary fiscal policy.

The difficulty of discerning what's too tight: Taylor rules and Japanese monetary policy

Observers have relied increasingly on simple reaction functions, such as the Taylor rule, to assess the conduct of monetary policy. Applying this approach to deflationary or near-zero inflation environments is problematic, however, and this paper examines two shortcomings of particular relevance to the Japanese case of the last decade. One is the unusually high degree of uncertainty associated with potential output in an environment of prolonged stagnation and deflation. Consequently, reaction function-based assessments of Japanese monetary policy are so sensitive to the chosen gauge of potential output as to be unreliable. The second shortcoming is the neglect of policy expectations, which become critically important as nominal interest rates approach zero. Using long-term bond yields, we identify five episodes since 1996 characterized by abrupt declines in Japanese inflation expectations. Policies undertaken by the Bank of Japan during this period did little to stabilize expectations, and the August 2000 interest rate increase appears to have intensified deflationary concerns.

Do Markets Care Who Chairs the Central Bank

This paper assesses the effects of central bank governor appointments on financial market expectations of monetary policy. To measure these effects, we assemble a new dataset of appointment announcements from 15 countries, and conduct an event study analysis on exchange rates, bond yields, and stock prices. The analysis reveals a significant reaction of exchange rates and bond yields to unexpected appointments. The reactions are not unidirectional, and thus do not suggest new governors suffer from a generic credibility problem. Federal Reserve chairman appointments stand out in terms of their unusually pronounced effects on financial markets.

The Fed's response to the financial crisis: Pages from the BOJ playbook, or a whole new ball game?

Like the Bank of Japan (BOJ) a decade ago, the U.S. Federal Reserve (Fed) has recently taken a number of unprecedented steps to stabilize its foundering financial system. This paper describes the Fed’s and the BOJ’s responses to their countries’ crises, highlighting the similarities and differences between the two banks’ policies. Both banks acted as lenders of last resort, providing the short-term funding necessary to prevent full-blown liquidity crises. Circumstances compelled the Fed to act much more quickly than the BOJ, however. And, in its direct involvement in the provision of credit to the private sector and its assumption of banks’ credit risk, the Fed has intervened in the financial markets more extensively than the BOJ. Disparities in the speed and scope of the two countries’ crises help explain the Fed’s relatively more aggressive response. The more heavily securitized financial structure in the U.S. and the Fed’s relaxed stance on credit risk also may account for the Fed’s more interventionist policies. JEL codes: E42, E58, E65. ∗Williams College Economics Department, Schapiro Hall 312, 24 Hopkins Hall Drive, Williamstown, MA, 01267, USA. kenneth.n.kuttner@williams.edu. Prepared for the March 24 2009 International Conference on the U.S. Economy, organized by the Policy Research Institute, Ministry of Finance, Japan. I am grateful to Shigenori Shiratsuka for his help in obtaining historical BOJ balance sheet data, and to Toshiki Jinushi, Takatoshi Ito, and the conference participants for their helpful comments.

Financial Stability and Inflation Targeting

The inflation-targeting (IT) monetary policy framework has gained wide acceptance in the past 20 years. The defining features of flexible IT are first, the announcement of a numerical inflation rate objective; second, a stated tolerance for temporary deviations of inflation from its target in order to smooth output fluctuations; third, a set of institutional arrangements designed to enhance transparency and accountability; and fourth, a response to financial developments only to the extent that they affect macroeconomic forecasts. Underlying this fourth attribute are the ideas that price stability promotes financial stability, and that the use of monetary policy to achieve financial stability objectives generally increases macroeconomic volatility. The 2007–09 financial crisis has raised questions about the degree to which the conventional IT framework is conducive to financial stability. Although existing evidence is mixed on monetary policys efficacy in attenuating financial booms, the crisis has spawned proposals to extend the IT framework to include a financial stability objective.

Macroeconomic Research, Present and Past

What is the state of macroeconomics? We answer this question by hand collecting information about the epistemological approaches, theoretical and empirical methods, and data sources used by macroeconomists in their research. During the past 40 years there has been an increasing reliance on mathematical theory, particularly DSGE models, with theory-based papers now occupying the majority of space in macro journals. This shift is mirrored by a decline in the use of empirical falsification methods testing theoretical predictions. Microeconometric techniques have displaced time series methods, and empirical papers increasingly rely on micro and proprietary data sources. We document a decline and subsequent resurgence of financial frictions appearing in macro theory. Finally, we find that topics outside of macroeconomics are studied in more than three fourths of macro field journal publications.