Monetary policy regimes, transmission mechanism, and responsiveness of fixed investment

We specify a VAR model for the US for 1980 to 2008 to investigate the statistical causal relationships between private non-residential fixed investment, the effective Federal funds rate, personal consumption expenditures, nonfinancial corporate profits, and the nonfinancial corporate credit market debt to test the validity of the macroeconomic relationships in a macro model. This statistical VAR approach to seek out meaningful causal relationships between variables can be contrasted with received attempts to impose an a priori macro model and then estimating it econometrically, which we suggest is flawed, as there is little consensus in macroeconomics as to which macro model is “best” for testing policy effectiveness. Furthermore we use the Toda-Yamamoto (1995) procedure to test for Granger causality, a procedure that the recent literature (e.g. Clarke and Mirza, 2006) indicates is preferred to using an error correction model. Our preliminary results show that the transmission mechanism does not work as expected; we find that fixed investment depends on the level of demand in the economy and profits but not on the interest rate. This cast doubt on the usual assumptions about how the monetary transmission mechanism is expected to work. The second part of the paper investigates the effects of the change in the monetary regime towards low and stable interest rates, a policy pursued by the US Fed since the beginning of 1990s. We find that the new monetary policy regime that the following effects:  (1) our VAR model does not support the hypothesis that low interest rates lead to higher fixed nonresidential investment; (2) low interest rate led to a search for higher yields through increasing risk, and (3) led to an increase in the demand for securitized assets, especially mortgage-backed securities, which eventually resulted in a housing bubble. The overall results therefore raise doubts about the effectiveness of low interest rates as a policy regime designed as a component of a counter-cyclical policy.