Discussion paper

Credit spreads, monetary policy and the price puzzle

Publisher
Economic indicators Inflation Monetary policy Australia
Description

Abstract:

Identifying the causal effect of monetary policy on inflation remains a challenge. Researchers frequently find evidence of a ‘price puzzle’: increases in the policy rate are followed by higher rather than lower inflation. This can be explained by the forward-looking behaviour of the central bank. Inflation does not rise in response to an increase in the policy rate but, instead, the central bank raises its policy rate when it expects inflation to increase in the future. To identify the true causal effects of monetary policy on inflation, it is hence necessary to control for this systematic policy response to expected inflation. For Australia, however, the price puzzle has been found even when controlling for the cash rate's systematic response to the Reserve Bank's own inflation forecasts.

I argue that this is due to an additional but omitted systematic response of the cash rate to credit market shocks. Easier credit market conditions lead to an economic expansion and higher inflation. Therefore, the Bank raises the cash rate – its policy rate – when credit spreads decline. However, the Bank's inflation forecasts do not fully capture the inflationary effect of easier credit conditions. As a result, cash rate changes are positively correlated with future inflation even when purging them of the cash rate's response to the Bank's inflation forecasts. Accordingly, I show that accounting for the cash rate's additional response to credit market conditions resolves the price puzzle. As expected, a higher cash rate reduces inflation and output growth, and raises the unemployment rate.

Publication Details
Issue:
RDP 2020-01
Publication Year:
2020