How Helpful Are Interest Rates?

So, if the Fed raises interest rates, how much and how soon will that help inflation? Per another projectI returned to Classic Review by Valerie Ramey. Here is her replication and update of two classic scores:

Two assessments of the impact of monetary policy shocks. Top: Christiano et al. (1999) identification. 1965m1–1995m6 full spec: solid black lines; 1983m1–2007m12 full specification: short blue dotted lines; 1983m1–2007m12, no money or reserves: long dotted red lines. The light gray bars represent the 90% confidence bars. Bottom: Romer and Romer’s money shock. Coibion ​​VAR 1969m3–1996m12: solid black lines; 1983m1–2007m12: short blue dotted lines; 1969m3–2007m12: long dotted red lines. Source: Ramy (2016).

The left panel shows us what usually happens to the federal funds rate after the Fed raises it. The right side shows the impact of the rate hike on level CPI. Inflation is the slope of the curve. The horizontal axis is quarters. The top panel uses vector autoregression. The bottom panel uses the Romer and Romer readings of the Fed minutes to highlight the monetary policy shock.

Top bar (VAR): Multiplied by 10, a 2 percentage point increase in the funds rate (blue line) could reduce cumulative inflation by one percentage point over three years (12 quarters) before it dries up. The black line is the most hopeful, but it’s essentially a 1980 experience. However, multiplying by 5, a 2 percentage point increase in the fund rate reduces inflation by only half a percentage point during those first three years (12 quarters), although after 10 years (40 quarters) you get a full percentage point reduction in the price level. .

Bottom panel (story): On the black and red lines that include the shock of 1980, a 3% interest rate hike does not lead to a marked reduction in inflation for the first three years. Ten years later, the price level is a respectable 4 percent lower, but that’s 0.4 percent per year of declining inflation. The blue lines excluding 1980 show a likely longer shock, but a 1% increase in the interest rate causes the price level to fall by only 1% in 10 years, i.e. 0.1% per year.

The problem lies in the ephemeral Phillips Curve, which I emphasized in my WSJ published. As far as VAR is concerned, the Fed is pretty good at inducing a recession. Here is the effect of Romer-Rohmer shocks on output and unemployment:

Simply causing a recession is not particularly effective in reducing inflation.

And I chose beautiful graphics. Many scores not found Any impact on inflation, or even positive:

Today, no theory, only facts. This is the empirical basis for the idea that the Fed can quickly stop inflation by raising interest rates. The underlying mechanism is doing its best in 50 years of work on this topic to separate causation from correlation and isolate the Fed’s actions from other factors that affect inflation. Perfect, no, but that’s what we have.

It may not be such a good idea to rely on the Fed to stop inflation itself. And I don’t mean more chatter and WIN buttons.