In macroeconomic models, economic agents are often assumed to perfectly observe the current state, but in reality they have to infer current conditions (nowcast). Because of information costs, this is not always easy. Information costs are not observable in the data but they can be proxied. A good proxy is disagreement on a near-term forecast because significant disagreement indicates that it is difficult to observe current economic conditions – ie higher information frictions. If the ability to nowcast varies over time, this may affect agents’ ability to respond to various shocks, including monetary policy shocks. My recent paper shows that when disagreement is higher, contractionary monetary policy brings down inflation, at the cost of a greater fall in economic activity.
What does disagreement look like in the data?
Disagreement is time varying. This is a stylised fact that has been captured in many different surveys, ranging from households, firms and professional forecasters, as well as for a variety of variables and a range of different forecast horizons, from nowcasts to 10 year ahead. The intuition behind this stylised fact is that people are not fully informed all the time and this naturally creates heterogeneity in beliefs. People use the information they have to take decisions and they take decisions not only once, but repeatedly over time. When making decisions, at each period, people choose whether it is beneficial to re-allocate their attention and by how much – making the degree of disagreement change over time.
As a starting point, it is useful to first familiarise ourselves with what disagreement looks like in the data. In my paper, disagreement is captured by the interquartile range of real GDP nowcast from the US Survey of Professional Forecasters (SPF). The SPF is one of the longest standing macroeconomic surveys, covering a variety of episodes in US macroeconomic history, including important economic events in the 1970s. Professional forecasters are some of the most informed group in the economy, so the SPF serves as a conservative benchmark for measuring information costs (information frictions). If there were an increase in information frictions, reducing a professional forecaster’s ability to predict macroeconomic aggregates – despite all publicly available information and forecasting techniques – then, one could expect even higher information frictions among firms and households.
How do varying degrees of information frictions affect the transmission mechanism of monetary policy?
To answer this question, I estimate state-dependent local projections on US data over the period 1970–2013. Local projections have been used to study time-varying effects, as they can be easily adapted for estimating state-dependent models. This method allows the response of output and inflation to a monetary policy shock to vary depending on how much disagreement there is. Monetary policy shocks are identified with a narrative approach à la Romer and Romer (2004) and shocks are estimated in both high and low disagreement periods.
The results show that when disagreement is higher, prices respond more sluggishly in response to monetary shocks. Stickier prices yield a flatter Phillips curve, leading to the empirical result that monetary policy has stronger effects on economic activity. During high disagreement periods, output responds fairly quickly to narrative monetary policy shocks. Conversely, the response of output is muted for a longer period when disagreement is lower. This result arises from the higher stickiness of prices in the high disagreement periods. At its trough, during heightened disagreement, prices fall by 0.8% and output by 1%. These results are robust to using forecasts (as opposed to nowcasts) and inflation (rather than output) disagreement.
Interpreting the empirical results according to rational inattention
To understand why disagreement could be crucial for monetary policy, I build a tractable rational inattention model where nowcasting is costly and firms decide how to optimally allocate their attention.
There is a fast growing literature using rational inattention models to understand monetary policy transmission. However, these models have not been used as much to explain the empirical evidence of state-dependent monetary transmission. In my paper, a rational inattention model provides an interpretation of the empirical results by demonstrating how price-setting changes with varying information frictions, as well as how it affects output and inflation. In periods where information frictions are severe, price-setting firms pay less attention to demand conditions. This implies that their prices will respond sluggishly to monetary policy shocks. The slower prices respond, the more ‘sticky’ prices appear. Stickier prices lead to smaller price adjustments. In conjunction with higher nominal rigidities, this inertia is price adjustments leads to a flatter Philips curve, yielding larger effects of monetary policy on output.
Dissecting disagreement and uncertainty
While there is a large literature on uncertainty, disagreement has received relatively less attention while possibly being more relevant in studying the macroeconomic implications of information frictions. A novel insight from this model is the ability to distinguish uncertainty versus disagreement. I demonstrate how the two features have different effects on the monetary transmission mechanism. Uncertainty about demand co-moves with disagreement when attention to aggregate demand is already relatively high, such that paying additional attention may result in a lower marginal benefit. Hence firms do not reallocate more attention to demand, resulting in a rise in disagreement. On the other hand, when the allocated attention to demand is still relatively low, an increase in demand uncertainty increases the benefit of monitoring demand. Firms could then optimally reallocate much more attention to monitoring demand, which decreases disagreement in demand.
My paper demonstrates the important role of central bank communication. During periods of low disagreement, contractionary monetary policy is able to reduce inflation significantly with a relatively small cost to output. This raises the potentially important role of communicating aggregate conditions to economic agents, enabling firms and households to internalise contractionary monetary policy, which effectively makes prices more flexible. This leads to a lower sacrifice ratio and enables an inflation-targeting central bank to better achieve its objectives.
Vania Esady works in the Bank’s Current Economic Conditions Division.
If you want to get in touch, please email us at firstname.lastname@example.org or leave a comment below.
Comments will only appear once approved by a moderator, and are only published where a full name is supplied. Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees.