Quantifying Monetary Policy Uncertainty: A New Index

Executive Summary

Financial, political and economic uncertainties impact the path of monetary policy and may cause the Federal Open Market Committee (FOMC) to keep rates on hold longer than expected. At its December 2018 meeting, the FOMC’s Summary of Economic Projections (SEP)’s dot plot indicated two rate hikes for 2019. The FOMC hiked the fed funds rate four times in 2018. But, despite a pickup in growth, muted inflationary pressures have kept the FOMC “patient” thus far in 2019.

In this report, we develop a new index to quantify monetary policy uncertainty, the MPU-index. To construct the MPU-index we utilize the Dynamic Factory Modeling (DFM) approach. Our index gauges economic, financial and political uncertainties to help decision makers accurately foresee the future path of monetary policy.

We identify seven (quantifiable) measures of monetary policy uncertainty: (1) probabilities of the FOMC’s rate decision, (2) inflation outlook probabilities, (3) business cycles/growth outlook probabilities, (4) the S&P500 index, (5) the yield spread, (6) the CBOE volatility index (VIX) and (7) the economic policy uncertainty (EPU) index.

Our model, which is fitted with data going back to 1970, gives us an opportunity to evaluate its historical performance during various business cycles and political environments. To analyze our model’s performance, we compare variations in the index to shifts in the monetary policy. For example, during the most recent business cycle, the MPU-index bottomed out in Q2-2017 then rebounded in the next quarter. The trend suggests increased policy uncertainty. Therefore, the FOMC’s shift to pause in 2019 is consistent with our MPU-index’s movements.

In this report, we estimate the statistical association of the MPU-index with changes in monetary policy, and we will highlight key drivers in a follow-up report.

A Theoretical Framework of Monetary Policy Uncertainty

To set monetary policy, the FOMC monitors financial markets, political developments, the labor market and price stability. Any uncertainty in these sectors could alter the monetary policy stance. In theory, if inflation falls below the FOMC’s target, the Committee would keep rates steady to combat softer-than-expected inflationary pressures.

At the December 2018 FOMC meeting, the SEP’s dot plot indicated two rate hikes in 2019. Though, due to changes in the economy, the Fed refrained from hiking rates. Currently, the target range of the fed funds rate remains unchanged from December and we expect the Fed to refrain from raising rates this year. Although growth has picked up over the past month, inflation has not followed. The Committee downgraded its read on inflation, noting that it is running below its 2% target. With stubbornly low inflation, the FOMC is expected to continue a “patient” stance.

Any shock (internal or external) to the economy would increase current monetary policy uncertainty. Depending on the source of the uncertainty, it may produce a heterogeneous effect on policy. Our method is to identify major sources of uncertainties and combine the sources into an index using the Dynamic Factory Modeling (DFM) approach.

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