First, how do we assess the effectiveness of monetary policy? By modifying an inflation volatility-based assessment ratio suggested by He (2017), this study presents a more consistent ratio to measure the effectiveness of monetary policy. The new ratio is defined as (real GDP/GDP trend)/σinflation. The standard deviation of inflation, the denominator of the ratio, is derived from the monthly annual rates of changes in the consumer price index (CPI) from January to December. The numerator quantifies the realized gross domestic product (GDP) growth potential. A higher realized growth potential or a lower inflation volatility can enhance the value of the assessment ratio, which precisely reflects the Fed’s dual policy goals: pursuing economic growth and maintaining price stability. A normalized ratio, dividing the assessment ratio by its average over the entire assessment period, reveals the underperformance (ratio< 1) or outperformance (ratio> 1) of monetary policy in a particular year, compared with the historical mean.
Second, why is the standard deviation of inflation more relevant in measuring the effectiveness of monetary policy than inflation rate? The standard deviation of inflation captures the unexpected changes in inflation or inflation risk that may exert more significant influence on consumption and investment decisions for many consumers and businesses than an inflation level that mainly reflects expected price changes. The expected inflation is a part of the risk-free interest rate, normally proxied by the 3-month T-Bill rate. Therefore, the empirical evidence that there is no significant effect of the standard deviation of inflation on the T-Bill rate can support the claim that the standard deviation of inflation represents inflation risk. In addition, we can validate the claim that the standard deviation of inflation is more relevant than the inflation rate, with more significant impacts on some important macroeconomic variables, such as GDP growth rate, consumer credit, business debt, and personal income.
Finally, what are the changes in the influence of monetary policy on the economy between the underperformance and outperformance periods suggested by the normalized assessment ratio? This study uses the effective funds rate (starting in 1955) and reserve requirements as monetary policy tools, with some control variables, to explain changes in the assessment ratio, inflation, standard deviation of inflation, GDP growth rate, and other variables in the two sub-periods.
This study uses a sample period of 1955-2016.