Appendix C: Further Results on Risk Management-driven Policy Decisions | RDP 2017-06: Uncertainty and Monetary Policy in Good and Bad Times

RDP 2017-06: Uncertainty and Monetary Policy in Good and Bad Times Appendix C: Further Results on Risk Management-driven Policy Decisions

Giovanni Caggiano, Efrem Castelnuovo and Gabriela Nodari

October 2017

C.1 Risk Management-driven Policy Rate Gap: Comparison with Evans et al (2015)

The risk management-driven policy rate gap documented in Section 5.3 points to a state-dependent response of policymakers to uncertainty. Here we contrast our VAR-based results with those one can produce by working with a Taylor rule à la Evans et al (2015). Our VAR model enables us to keep track of feedback effects between the economy and the policy rate. The Taylor rule estimated by Evans et al (2015) does not. Further, they focus on the information possessed by the FOMC in real time, while our VAR framework employs revised data. Hence, if the Evans et al (2015) model produced a risk management-driven policy rate gap in line with ours, we would be reassured about the credibility of our policy rate gap. We then turn to Evans et al's (2015) model, which is the following:

where π_t,k stands for the average annualised inflation rate from t to t + k, π^* models the inflation target, x_t,q is the average output gap from t to t + q, s_t is a risk management proxy, and E_t denotes expectations conditional on information available to the FOMC at time t. The coefficients β, γ, and μ are fixed over time, while R^* is the Taylor rate conditional on an inflation rate equal to the target, a zero output gap, and a consideration of uncertainty by the policymakers μ set to zero. In this case, the natural real rate of interest is r^* = R^* + π^*.

Given that the FOMC has a preference for implementing variations in the policy rate in a smooth manner, and that it does not have full control of interest rates, the polynomial and the zero mean, constant variance error term ν_t are also modelled. As regards to the former, L is the lag operator, while N denotes the number of lags of the federal funds rate. Combining the equations above yields to the following estimation equation:

where b_i,i = 0,1,2,3 are nonlinear functions of the structural parameters β, γ, μ, R^*, and π^*.

The estimation of the above equation confirms that we are able to replicate the results documented in Evans et al (2015).^[29] In particular, we obtain a significant coefficient for the long-run response of the policy rate to the (standardised) VXO, whose size is −0.43.^[30] To get closer to our nonlinear VAR analysis, we then estimate the following state-dependent version of the Taylor rule:

where D_t is a zero/one dummy taking a value equal to one in correspondence of quarters classified as ‘recessions’ by the NBER and zero otherwise, and s_t is now the non-standardised VXO, which is the proxy for uncertainty exploited in Bloom (2009) to identify the uncertainty shock dummy. This equation has the potential of capturing nonlinearities in the relationship between the policy rate and uncertainty. We estimate this equation over the sample 1987:Q1–2008:Q2 to align the end-of-sample of this empirical analysis to the one we conduct with our VAR. Interestingly, we get a more aggressive long-run response of the policy rate to uncertainty in recessions, and we verify that the restriction b₃ = b₄ is rejected at a 1 per cent level. We use this version of the Taylor rule to compute the risk management-driven policy rate gap consistent with this nonlinear Taylor rule as .

Figure C1 plots the Taylor rule policy rate gap obtained as explained above. Evidently, the values of the policy rate gap in recessions are much larger, with peaks (in absolute values) of 114 (2001:Q4), 109 (2008:Q1) and 101 (1990:Q4) basis points. If one considers that the lack of a feedback mechanism accounting for different paths of the policy rate, their effects on the economic system, and the feedback on the regressors of the Taylor rule are likely to downplay the dynamics effects induced by the role played by risk management in monetary policy setting, this result can be seen as reasonably close to the one documented in our paper.

Figure C1: Taylor Rule Risk Management-driven Policy Rate Gap

C.2 Risk Management: Narrative Evidence

Table C1 collects excerpts from the FOMC documents with references to uncertainty, risk, and risk management around the dates corresponding to the uncertainty shocks we identify. The reading of these documents confirms that uncertainty was an element carefully considered by the members of the FOMC when deciding over the federal funds rate setting.

Table C1: References to Uncertainty in FOMC Meetings
Uncertainty shock	Reference	Statements
Cuban missile crisis	FOMC HM 23/10/1962 meeting	‘With regard to policy, Mr. Swan [President of the Federal Reserve Bank of San Francisco] expressed the view that the uncertainties presented by the international situation, and in particular the Cuban crisis, ruled out doing anything at the moment except to maintain as even a keel as possible.’ (p 33)
Assassination of JFK	FOMC HM 03/12/1963 meeting	‘… there was little immediate effect that could be discerned, but that uncertainty had been introduced into the current economic and financial scene’ (p 47) ‘System open market operations shall be conducted with a view to cushioning any unsettlement that might arise in money markets stemming from the death of President Kennedy and to maintaining about the same conditions in the money market as have prevailed in recent weeks, while accommodating moderate expansion in aggregate bank reserves.’ (p 52)
Vietnam build-up	FOMC HM 23/08/1966 meeting	‘In view of those developments, the substantially increased rate structure, and the market uncertainties that existed, it seemed to him [Mr Swan, President of the Federal Reserve Bank of San Francisco] the Committee should not take further action to tighten irrespective of market forces.’ (p 91)
Cambodia, Kent State	FOMC MA 26/05/1970 meeting	‘Attitudes in financial markets generally are being affected by the widespread uncertainties arising from recent international and domestic events … in view of current market uncertainties and liquidity strains, open market operations until the next meeting of the Committee shall be conducted with a view to moderating pressures on financial markets …’ (pp 3–4)
OPEC I, Arab-Israeli War	FOMC RPA 17–18/12/1973 meeting	‘On November 30, however, the available members of the Committee concurred in a recommendation by the Chairman that, in light of current uncertainties regarding the economic outlook and the sensitive state of financial market psychology, current money market conditions be maintained for the time being.’ (p 7)
Franklin National	TIME 08/10/1974	‘In 1974, as Franklin began to collapse, the Federal Reserve's strategy was to lend it money in order to buy time for a bigger strategy … “The entire financial world,” Arthur Burns, the chairman of the Federal Reserve Board, told TIME shortly after, “can breathe more easily, not only in this country but abroad.”’ (Frizell 2014)
OPEC II	FOMC RPA 19/12/1978 meeting	‘The uncertainties in the current situation also provided the grounds for the proposal to base the Committee's objective for money market conditions altogether on the incoming evidence on the behavior of the monetary aggregates: It was suggested that whether fundamental economic conditions were strong or weak would inevitably become evident in renewal of rapid monetary expansion or in continuation of sluggish expansion, leading in either case to appropriate objectives for money market conditions.’ (pp 10–11)
Afghanistan, Iran hostages	FOMC CCT 29/04/1980 conference call	‘I [Mr Forrestal, Vice President, Federal Reserve Bank of Atlanta] think the greater risk at this point, both domestically and internationally, would be to run the risk of underkill on inflation. Without any reduction of the inflation rate we'd be making a serious mistake if we didn't [show] some resistance at this point to a precipitous decline in interest rates. I think they've fallen enough already and I would like to see the Committee opt for resisting [further declines] at the 14 to 14-1/2 percent level, wait a week to see what happens, and consult again.’ (p 6)
Monetary cycle turning point	FOMC RPA 24/08/1982 meeting	‘The Committee decided that somewhat more rapid growth in the monetary aggregates would be acceptable depending upon evidence that economic and financial uncertainties were fostering unusual liquidity demands for monetary assets and were contributing to substantial volatility in interest rates.’ (p 9)
Black Monday	FOMC RPA 15–16/12/1987 meeting	‘The Committee recognizes that still sensitive conditions in financial markets and uncertainties in the economic outlook may continue to call for a special degree of flexibility in open market operations.’ (p 18)
Gulf War I	FOMC RPA 18/12/1990 meeting	‘Even under the assumption that the Persian Gulf situation would be more settled and oil prices lower, restoration of the degree of confidence needed to induce a substantial upturn in spending was not assured.’ (pp 7–8) ‘At the conclusion of the Committee's discussion, all of the members indicated that they could support a directive that called for some slight further easing in the degree of pressure on reserve positions …’ (p 14)
Asian crisis	FOMC M 12/11/1997 meeting	‘The current momentum of the expansion, together with broadly supportive financial conditions and favorable business and consumer sentiment, suggested that economic growth was likely to be well maintained … As a consequence, the members agreed that there remained a clear risk of additional pressures on already tight resources and ultimately on prices that could well need to be curbed by tighter monetary policy. But the members also focused on two important influences that were injecting new uncertainties into this outlook. Turmoil in Asian financial markets and economies would tend to damp output and prices in the United States … The second influence was the apparently sharp increase in productivity in the second and third quarters … While developments in Southeast Asia were not expected to have much effect on the U.S. economy, global financial markets had not yet settled down and further adverse developments could have greater-than-anticipated spillover effects on the ongoing expansion. In this environment, with markets still skittish, a tightening of U.S. monetary policy risked an oversized reaction … At the conclusion of the Committee's discussion, all but one member supported a directive that called for maintaining conditions in reserve markets that were consistent with an unchanged federal funds rate of about 5-1/2 percent and that retained a bias toward the possible firming of reserve conditions and a higher federal funds rate during the intermeeting period.’
Russian, LTCM default	FOMC M 29/09/1998 meeting	‘In a telephone conference held on October 15, 1998, the Committee members discussed recent economic and financial developments and their implications for monetary policy. Risk aversion in financial markets had increased further since the Committee's meeting in September, raising volatility and risk spreads even more, eroding market liquidity, and constraining borrowing and lending in a number of sectors of the financial markets. Although indications of any softening in the pace of the economic expansion across the country remained sparse, the widespread signs of deteriorating business confidence and evidence of less accommodative domestic financial conditions suggested that the downside risks to the expansion had continued to mount. ‘Against this background, a consensus emerged in favor of a 1/4 percentage point reduction in the federal funds rate …’
9/11	FOMC M 06/11/2001 meeting	‘The staff forecast prepared for this meeting emphasized the continuing wide range of uncertainty surrounding the outlook in the wake of the September attacks. The mild downturn in economic activity in the third quarter was seen as likely to deepen over the remainder of the year and to continue for a time next year. However, the cumulative easing that had occurred in the stance of monetary policy, coupled with the fiscal stimulus already in place and prospective additional measures, would provide support for economic activity … However, the strength and timing of the eventual recovery remained subject to question especially in light of the marked degree of uncertainty that surrounded the prospects for further fiscal policy legislation, developments in the war against terrorism, and weakness in foreign economies … In the Committee's discussion of policy for the intermeeting period ahead, all the members indicated that they could support a proposal calling for further easing in reserve conditions consistent with a 50 basis point reduction in the federal funds rate to a level of 2 percent.’
Worldcom, Enron	FOMC M 06/11/2002 meeting	‘Business investment expenditures continued to be constrained by a high degree of uncertainty and related caution … All the members indicated that, in light of the contemplated 50 basis point easing action, they could support a shift in the Committee's assessment of the risks to the economy from tilted toward economic weakness to balanced for the foreseeable future …’
Gulf War II	FOMC M 18/03/2003 meeting	‘The staff forecast prepared for this meeting continued to suggest that economic expansion would be muted for a time. Faced with the likely onset of war in the very near term and the large uncertainties relating to its aftermath, businesses and consumers were likely to hold down their spending … In the Committee's discussion of current and prospective economic developments, members commented that an unusually high degree of uncertainty had made it very difficult to assess the factors underlying the performance of the economy … In light of these considerable uncertainties, the members agreed that heightened surveillance of evolving economic trends would be especially useful in the weeks ahead … the Committee in the immediate future seeks conditions in reserve markets consistent with maintaining the federal funds rate at an average of around 1-1/4 percent.’
Notes: FOMC HM: FOMC Historical Minutes, FOMC MA: FOMC Minutes of Actions, FOMC RPA: FOMC Record of Policy Actions, FOMC CCT: FOMC Conference Call Transcript, FOMC M: FOMC Minutes Sources: Federal Open Market Committee: Transcripts and Other Historical Materials; Frizell (2014)

Footnotes

The replication files containing their datasets are available at <https://www.chicagofed.org/publications/working-papers/2015/wp2015-03>. We focus on the 30-day forward average of the target rate following each FOMC meeting as policy rate, and on the Greenbook measures of CPI inflation and output gap expectations for modelling the response to inflation and real activity. A detailed description of the data is provided in Evans et al's Appendix, which is available here: <https://www.chicagofed.org/~/media/publications/working-papers/2015/wp2015-03-main-appendix-pdf.pdf?la=en>. Given our choice of proxying uncertainty with the VXO, we focus on the case in which the measure of uncertainty is the VXO. Following Evans et al, we first standardise the VXO in order to interpret the long-run response of the policy rate as the reaction to a one standard deviation increase in uncertainty. We then estimate the last equation reported above via least squares, focusing on the sample 1987:Q1–2008:Q4, which is the same sample they focus on. We account for heteroskedasticity by modelling the White-correction of the VCV matrix, as they do. [29]

See Table 9 in Evans et al (2015, p 50). [30]