Untangling Fed Communications: New Evidence on Information Effects

Disentangling Neo-Fisher and central bank information effects

This working paper by Stephanie Schmitt-Grohé and Martín Uribe tackles a fundamental question in monetary economics: when interest rates, prices, and economic activity all move in the same direction after a monetary disturbance, which mechanism is primarily responsible – the central bank information (CBI) effect or the neo-Fisher effect?

Both effects can produce similar outcomes where a monetary tightening (interest rate increase) leads to higher inflation and expanded real activity, making it challenging to distinguish between them empirically. The authors argue that separate estimates of these effects risk confounding one with the other, necessitating a joint analysis. The authors develop a new-Keynesian dynamic general equilibrium model with several key features:

1. Core components:
   – Sticky prices with quadratic adjustment costs à la Rotemberg
   – Habit formation in household preferences
   – Nominal and real rigidities
   – Multiple types of shocks driving the economy
2. Shock structure:
   There are permanent and transitory monetary shocks that are designed to generate neo-Fisher effects, where monetary policy changes can lead to co-movement of interest rates, inflation, and output in the same direction. Second, the model includes two distinct preference shocks affecting household utility – one component that households observe but the central bank does not directly respond to, and another component that the central bank can observe and actively responds to in its policy rule, thereby creating the central bank information channel. This second preference shock allows the central bank to have superior information about economic conditions and respond preemptively to stabilize the economy. Finally, the model incorporates both permanent and transitory productivity shocks that affect the economy’s production capacity and growth trends over different time horizons.
3. Monetary policy rule:
   The central bank follows an augmented Taylor rule that responds to:
   – Inflation and output gap (standard components)
   – The preference shock directly (central bank information channel)
   – Both permanent and transitory monetary shocks
4. Structure and data
   The authors examine two information structures: full information where private agents observe all shocks individually, and imperfect information where agents only observe aggregated preference shocks and the Taylor rule’s stochastic component without seeing individual shock components. Their estimation uses quarterly U.S. data from 1961:Q3 to 2019:Q4 (excluding COVID-19), focusing on real GDP per capita growth, changes in the Federal Funds rate, and the interest rate-inflation differential.

Findings

• Neo-Fisher effect:
  – Permanent monetary shocks explain 20-30% of inflation variance changes
  – When a permanent monetary shock increases nominal interest rates and inflation by 1 percentage point long-term, it produces short-run increases in interest rates, inflation, and output. Output rises by 15 basis points on impact and peaks at 20 basis points after two quarters
• CBI effect:
  – The preference shock explains about 50% of nominal interest rate movements
  – Direct output and inflation responses are small, but this reflects the central bank’s success in stabilizing the economy
  – When the CBI channel is counterfactually shut down, this shock explains over 50% of inflation movements and 20% of real activity
• Traditional monetary shocks:
  Standard transitory monetary shocks play a minor role in explaining movements in interest rates, inflation, and output
• Information structure results:
  Surprisingly, full and imperfect information cases deliver similar equilibrium dynamics. The reason is that the three imperfectly observed shocks (permanent monetary, CBI demand, and standard monetary) produce “starkly different dynamics after the period of impact, allowing private agents to learn quickly about the nature of the disturbances.”
• Neo-Fisher mechanism:
  When firms observe a permanent increase in the monetary shock, they anticipate higher long-run inflation. Due to price adjustment costs, they begin raising prices immediately. Since inflation adjusts faster than interest rates initially, real interest rates fall, stimulating economic activity.
• CBI mechanism:
  The central bank responds directly to demand shocks that private agents cannot observe separately. This allows the central bank to raise real interest rates in line with natural rate increases while keeping inflation and output near target levels – something difficult to achieve under standard Taylor rules.

Central Bank Information or Neo-Fisher Effect?
Authors: Stephanie Schmitt-Grohé, Martín Uribe
From: Columbia University

Decomposing Fed communication effects

The paper by Marek Jarociński, Peter Karadi develops a novel identification strategy to simultaneously distinguish between three types of shocks that contaminate high-frequency monetary policy surprises around Federal Reserve announcements:

Three-shock framework:

1. Monetary policy (MP) shock: Pure exogenous policy deviations from systematic rules
2. CBI shock: Market learning about economic conditions from Fed communications
3. Fed response to news (FRN) shock: Market misperceptions of the Fed’s systematic policy rule aggressiveness

Jarociński and Karadi employ three key identification restrictions:

1. High-frequency co-movement patterns: MP and FRN shocks generate negative correlations between interest rate and stock price surprises, while CBI shocks generate positive correlations
2. Predictability by public news: FRN shocks are associated with the component of interest rate surprises explained by fresh public economic news
3. Heteroskedasticity: Different shock prevalence between FOMC and non-FOMC events (speeches, minutes releases, etc.)

The analysis is extended beyond FOMC statements to include 1,609 Fed communication events from 1988-2024.

Findings

• Central bank information effects remain robust:
  The paper confirms that CBI effects are a “robust feature of the data” even when controlling for FRN effects. Favorable CBI shocks lead to:
  – Stock price increases and improved financial conditions
  – Temporary economic booms with rising activity and prices
  – Persistent positive macroeconomic impacts
• Fed response to news effects are limited:
  The authors find that FRN shocks have “marginal impact” in monthly data. While FRN shocks:
  – Play a significant role in daily financial market responses
  – Are more prevalent around FOMC meetings than other Fed communications
  – Their macroeconomic effects are limited and contractionary rather than expansionary
• Purified monetary policy shocks:
  When cleaned of both CBI and FRN contamination, monetary policy shocks generate responses “in line with theoretical predictions”:
  – Temporary downturns in economic activity
  – Reductions in price levels
  – Deterioration of financial conditions

Disentangling Monetary Policy, Central Bank Information, and Fed Response to News Shocks
Authors: Marek Jarociński, Peter Karadi
From: ECB