How much do interest rates help?

So if the Fed raises interest rates, how much and how long will inflation help? For another project, I went back to the classic review by Valerie Ramey. Here is his replica and update of two classic estimates:

Two estimates of the effect of monetary policy shocks. Top: Cristiano et al. (1999) identification. Complete Specifications 1965m1–1995m6: solid black lines; Complete specifications 1983m1–2007m12: short dashed blue lines; 1983m1–2007m12, omits cash and reserves: long dashed red lines. The light gray bands are 90% confidence bands. Bottom: Romer and Romer monetary shock. Coibion ​​VAR 1969m3–1996m12: solid black lines; 1983m1–2007m12: short dashed blue lines; 1969m3–2007m12: long dashed red lines. Source: Ramey (2016)

The left side tells us what the federal funds rate typically does after the Fed raises it. The right shows the effect of the rate hike on level of the CPI. Inflation is the slope of the curve. The horizontal axis is quarters. The top panel uses a vector autoregression. The bottom panel uses the Romer and Romer reading of the Fed minutes to isolate a monetary policy shock.

Upper box (VAR): Multiplying by 10, a 2 percentage point increase in the funds rate (blue dash) could reduce cumulative inflation by one percentage point over three years (12 quarters), before it runs out. The black line is the most promising, but it is essentially the 1980 experience. However, multiplying by 5, a 2 percentage point increase in the fund rate reduces inflation by only half a percentage point in those first three years (12 quarters ), even if after 10 years (40 quarters) a reduction of the entire percentage point of the price level is obtained.

Bottom panel (narrative): In the black and red lines that include the 1980 shock, a 3% increase in the interest rate does not produce a noticeable decline in inflation in the first three years. 10 years later, the price level is a decent 4% lower, but that’s a 0.4% reduction in inflation per year. The blue lines that exclude 1980 show a plausible shock of longer duration, but an interest rate higher than 1% only produces a 1% lower price level in 10 years, m 0.1% per year .

The problem is the ephemeral Phillips curve, which I emphasized in my WSJ work. In VARs, the Fed is pretty good at inducing a recession. Here are the effects of the Romer-Romer shocks on production and unemployment:

It’s just that inducing recessions isn’t particularly effective in bringing down inflation.

And I chose good looking graphics. Many estimates do not find whatever effect on inflation, or even positive:

No theory today, just facts. This is the empirical basis for the idea that the Fed can quickly stop inflation by raising interest rates. The underlying mechanism does the best that 50 years on the matter have been able to do to separate causation from correlation and to isolate Fed actions from other inflation influences. Perfect, no, but this is what we have.

Maybe relying on the Fed to stop inflation alone isn’t a great idea. And I don’t have in mind more jaw-dropping and WIN buttons.

updated: Some Twitter commentators claim that we don’t really get much from “normal times” and that we need to look to big “regime shifts”. 1980 is an example, and the results with and without 1980 speak for themselves. But maybe that’s the point. If so, then it will take “regime change” to tame inflation, not the usual “tools”.