James Hamilton of Econbrowser has announced a new paper he has co-authored: The Market-Perceived Monetary Policy Rule:
We introduce a novel method for estimating a monetary policy rule using macroeconomic news. Market forecasts of both economic conditions and monetary policy are affected by news, and our estimation links the two effects. This enables us to estimate directly the policy rule agents use to form their expectations, and in so doing flexibly capture the particular dynamics of policy response. We find evidence that between 1994 and 2007 the market-perceived Federal Reserve policy rule changed: the output response vanished, and the inflation response path became more gradual but larger in long-run magnitude. In a standard model we show that output smoothing caused by a larger inflation response magnitude is offset by the more measured pace of response. Our response coeffcient estimates are robust to measurement and theoretical issues with both potential output and the inflation target.
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Our baseline results for the 1994-2007 sample suggest the market perceives that the Federal Reserve gradually responds to inflation and real activity. Similar to previous literature working on post-Volcker data, we find the Federal Reserve follows the Taylor Principle, a greater than one-for-one response to inflation. We also find evidence that the market-perceived monetary policy rule changed over our sample. During the 1990s market-perceived policy responded robustly to output and quickly to inflation; during the 2000s market-perceived policy doesn’t respond to output and responds at a more measured pace to inflation, though its long-run inflation response is greater than before. We quantify the importance of the inflation response path and long-run magnitude in a standard model, and find that raising the long-run magnitude is effective at lowering inflation volatility while making the path more gradual is counterproductive. Our baseline results were found to be robust to alternative possible specifications.