Thursday, October 04, 2012

Calvo, we have a problem

We are operating in an era where the Fed is using forward guidance to condition the public's expectation of future interest rates.  Having already pushed the policy rate to zero, the Fed is now left with promising to keep it there in future periods.

An obvious question is, does this work? Or, in what class of models does this work?

 From this recent Cleveland Fed working paper, it seems like part of the answer is, not in the basic DSGE models everyone uses.

 I'll let the authors tell you themselves:

 Our experiments consider a fully anticipated and unconditional lowering of the monetary policy rate for a finite number of periods. We find that the workhorse Calvo (1983) models of time dependent pricing currently used for monetary policy analysis deliver unreasonably large responses of inflation and output in response to such a policy. Furthermore, if there are endogenous state variables, these models suggest that the initial responses can become arbitrarily large as the duration of the fixed rate regime approaches some critical value and then switch sign and become arbitrarily negative as this critical value is exceeded slightly. For empirically realistic models such as the Smets and Wouters (2007) model, the critical duration for which these asymptotes occur is around eight quarters - well within the duration of the low interest rate environment in the U.S. following the financial crisis. 

So, either the promise is not credible, the models are wrong, or maybe both?

Let's be clear that is paper is not done by hacks. One of the authors is Tim Fuerst, and he is the real deal.


2 comments:

Doc Merlin said...

If the goal were to improve the economy. Then you would be right, the Fed's actions won't work. The goal however is to prop up banks/Fanny/Freddy and to monetize some of the US debt. This goal is bound to succeed.

BR said...

Re: "We are operating in an era where the Fed is using forward guidance to condition the public's expectation of future interest rates." I bet 98% of the public has no idea what the Fed is doing, and 90% have no expectation of future interest rates.