Using Stock Prices to Help Identify Unconventional Monetary Policy Shocks for External Instrument SVAR

In times when short-term policy rates are at or near the zero lower bound, central banks use unconventional policies such as forward guidance and quantitative easing to influence the slope of the yield curve. In this paper, we analyze the dynamic responses of key U.S. macroeconomic variables to the Fed’s slope policy in the newly developed instrumental variable structural VAR framework. We contribute to the literature by using stock price movements to help identify policy surprises that are free of the Fed information effect, namely some of the interest rate movements are not policy-driven, but are results of the financial market becoming aware of the Fed’s view about economic fundamentals. We use a heteroskedasticity identification approach, taking advantage of changes in the relative dominance of economic shocks around different types of macroeconomic announcements. Analysis based on the cleaned policy shocks suggests that the slope policies successfully aided economic recovery by lowering unemployment and overall credit costs. More importantly, we show that the Fed information effect, while a valid concern, is not strong enough to bias the estimated policy effect substantially. This finding supports the approach commonly seen in the literature that ignores the Fed information effect and treats high-frequency changes around FOMC announcements as pure policy surprises