RDP 2017-06: Uncertainty and Monetary Policy in Good and Bad Times 6. Conclusions

This paper quantifies the effects of uncertainty shocks in good and bad times and investigates the role that US monetary policy plays in tackling such shocks. Using a nonlinear VAR model, we show that the contractionary effects of uncertainty shocks are stronger when they hit the economy during recessions compared to expansionary times.

Counterfactual simulations, conducted to assess the role of systematic monetary policy, point to policy ineffectiveness in the short run. Policy effectiveness increases in the medium run, especially in good times. In particular, monetary policy plays an important role in reducing the probability of entering a recession if the uncertainty shock occurs during an expansion. This is because expansionary systematic policy mitigates the drop in real economic activity caused by the uncertainty shock. However, the policy response doesn't help as much if the economy is already in a recessionary state. These empirical findings lend support for theoretical models like those developed by Vavra (2014), Berger and Vavra (2015), and Baley and Blanco (2016), which predict a reduced ability of monetary policymakers to influence output in the presence of high uncertainty.

We also provide empirical and narrative evidence of a risk management-approach adopted by the Federal Reserve during the period we analyse. Economic uncertainty affected the decisions taken by the Federal Open Market Committee, which acted as a risk manager hedging against downside risks. This led US policymakers to keep the federal funds rate lower than that suggested by changes in inflation and output. Our evidence, based on counterfactual simulations conducted within a multivariate nonlinear VAR model, lines up with that proposed by Evans et al (2015) and Seneca (2016), who work with augmented Taylor rules. We corroborate our results by narrative evidence coming from the minutes of the FOMC meetings.

Overall, our findings support a research agenda aimed at identifying state-dependent frictions that can generate different dynamic responses to structural shocks in recessions and expansions. In terms of stabilisation policies, high uncertainty reduces the sensitivity of output to stimulus interventions, above all in recessions. Our findings call for the design of state-dependent policy responses, possibly closer to first moment policies in expansions, but clearly different from them in recessions. Blanchard (2009) and Bloom (2014) call for larger policy stimuli in bad times, as well as second moment policies like stabilisation packages designed to reduce systemic risk. Baker et al (2016) point to the role of clear policy communication and steady policy implementation. Basu and Bundick (2015) find that, in economies characterised by a binding zero lower bound, the inability of the central bank to tackle adverse shocks may contribute to increasing uncertainty about future shocks, and lead to severe contractions. They advocate the use of state-dependent policies, and in particular forward guidance, to exit the zero lower bound. Evans et al (2015) and Seneca (2016) show that it is optimal to hold the policy rate lower than otherwise when expectations of improving future economic conditions are surrounded by uncertainty. Our results suggest that state-dependent policy prescriptions like these should be carefully assessed in order to exit phases characterised by severe economic conditions in the presence of high uncertainty.