RDP 2017-06: Uncertainty and Monetary Policy in Good and Bad Times 4. Results

Are the real effects of uncertainty shocks state-dependent? Figure 3 plots the estimated dynamic responses of employment and industrial production to an uncertainty shock in recessions and expansions, along with 68 per cent confidence bands. The size of the shock in all scenarios is normalised to induce an on-impact response of uncertainty equal to one. The macro variables react negatively and significantly in both phases of the business cycle. However, the responses are clearly asymmetric. In recessions, the peak short-run response of industrial production is about −2.5 per cent; while that of employment is about −1.5 per cent. The same values in expansions are −1.5 and −0.9 per cent. As shown below, these differences are statistically significant. Hence, we find evidence in favour of an asymmetric response of real activity to uncertainty shocks across the business cycle.^[16]

Our results are in line with recent contributions by Caggiano et al (2014), Nodari (2014), Ferrara and Guérin (2015), Casarin et al (2016), and Caggiano, Castelnuovo and Figueres (2017), who also find that uncertainty shocks have a larger effect on real activity when they occur in recessions. This evidence is robust to a variety of checks, including:

1. different identifications of uncertainty shocks based on: a dummy that focuses only on events associated with terror, war, or oil events; the use of the VXO itself; the use of an alternative dummy that identifies extreme events conditional on the one-month ahead financial uncertainty indicator developed by Ludvigson et al (2015)
2. different calibrations of the smoothness parameter γ
3. the use of unemployment as transition indicator
4. the addition of control variables such as credit spreads, house prices, and a long-term interest rate.

In all cases, our results confirm the evidence of asymmetric responses of industrial production and employment (in terms of severity of the recession, speed of the recovery, and overall dynamics). For the sake of brevity, we discuss these robustness exercises in Appendix B.

4.2 Systematic Monetary Policy Response

Next, we analyse the response of systematic monetary policy to macroeconomic uncertainty. To do this, we look at the responses of both prices and the federal funds rate (Figure 4).

An uncertainty shock triggers a negative reaction of prices that is statistically significant in recessions only. Prices decrease in the short run and then gradually return to their pre-shock level. The interest rate decreases significantly, both in recessions and expansions. However, the differences between the two states are remarkable in terms of dynamics and quantitative response. When an uncertainty shock hits the economy in good times, the interest rate decreases by about 0.8 percentage points at its peak, and the reaction is short-lived. When an uncertainty shock hits in a recession, the policy rate decreases by about 2 percentage points, and remains statistically below its initial level for a prolonged period of time. These impulse responses support the view put forward by Basu and Bundick (2017) and Leduc and Liu (2016) that uncertainty shocks act as demand shocks.

4.3 Statistical Significance of the Differences

The evidence proposed so far points to differences in the response of real and nominal indicators to an uncertainty shock when quantified in recessions versus expansions. How relevant is this result from a statistical standpoint? Figure 5 plots the differences in the responses of industrial production, employment, prices, and the federal funds rate in recessions versus expansions. Industrial production, employment, and the federal funds rate react significantly stronger to uncertainty shocks in recessions. However, we do not find significant evidence in favour of an asymmetric reaction of prices. Hence, from a statistical standpoint, the more aggressive systematic policy reaction estimated in recessions is likely to be driven by the response of real activity. In the rest of the paper we will focus on the responses of industrial production and employment with the aim of understanding if the effectiveness of the Federal Reserve's systematic policy (in terms of business cycle stabilisation) was different in recessions compared to expansions.

Footnote

We model nonlinearities only with respect to the state of the economy. Impulse responses may also depend on the size and sign of the shock. While we do not investigate the effects of unexpected decreases in uncertainty, robustness checks suggest a negligible impact as for the size of the shock. [16]