Changes in monetary regimes and the identification of monetary policy shocks: Narrative evidence from Canada

Abstract

Quantifying the effects of monetary policy is challenging and has generated a vast literature in empirical macroeconomics. Much of this literature uses vector autoregressions (VARs), identified with different approaches, and finds that the effects of monetary policy for the U.S. are relatively modest, with peak decline estimates ranging between 0.3 and 1 per cent for output following a 100-basis-point monetary innovation. However, Romer and Romer (2004; R&R henceforth) find much larger effects of U.S. monetary policy shocks using narrative methods. This strategy uses historical records to construct a series of intended interest rate changes at meetings of the Federal Open Market Committee (FOMC) and then isolate the innovations to these interest rate changes that are orthogonal to the Federal Reserve's information set. A 100-basis-point shock from the R&R shock series translates into output and price level peak declines larger than 4 per cent. The study by Cloyne and Hurtgen (2016) extends the narrative approach to the U.K. and is, to our knowledge, the only one applying narrative methods to a country other than the U.S. Another important body of literature in monetary economics has documented important shifts in the conduct of monetary policy in the U.S. and abroad. Some prominent papers, such as Clarida et al. (2000), document that U.S. monetary policy has become more responsive to expected inflation after the Volcker disinflation. There is also evidence that monetary policy rules in small open economies have also changed significantly. For example, Alstadheim et al. (2013) show that the central banks of the U.K., Sweden and Canada shifted away from responding to exchange rate movements around the 1990s, when these countries implemented inflation-targeting (IT) regimes. Our paper builds on these two strands of literature and applies the narrative approach to Canada, providing new evidence on the macroeconomic effects of monetary policy and highlighting the importance of changes in the conduct of systematic monetary policy. We use historical documents to construct a series of intended changes in the target policy interest rate along with a novel database of real-time data and forecasts assembled from the Bank of Canada's staff economic projections from 1974 to 2015, to isolate the innovations to the intended policy changes that are orthogonal to the policymakers' information set. We find that following a 100-basis-point monetary policy shock, real monthly GDP has a peak decline of 1.0 per cent about 18 to 24 months after the shock and is less than 0.5 per cent lower after three years, while the price level (consumer price index) response is weaker and takes longer to materialize, falling by 0.4 per cent after three years. We show that it is crucial for these results to depart from R&R in two important ways: (i) by controlling for U.S. interest rates as well as the USD/CAD exchange rate in the policy-makers' information set, and (ii) by accounting for the structural break in the conduct of monetary policy caused ...

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