Abstract
Summary This paper estimates the response of consumer prices to a monetary policy shock in Switzerland. We find that there is no evidence of a price puzzle at the aggregate level. This is because our factor-augmented vector autoregression (FAVAR) avoids misspecification by including more information than a traditional VAR. However, the response is still delayed by at least four quarters, partly because there is a price puzzle in some sectors. In particular, rents tend to rise after a monetary policy tightening because there are legal provisions in Switzerland which link them to interest rates. But durable goods prices also rise, which is consistent with the existence of a cost channel of monetary policy.
Highlights
The effect of monetary policy on prices and output is traditionally analysed in vector autoregressions (VARs)
The decline is delayed by at least four quarters. This result holds, whether we look at the response of the aggregate CPI or at an average response of disaggregate prices. We show that this is because the factor-augmented vector autoregression (FAVAR) includes more information than a traditional three-variable VAR
The FAVAR allows us to analyse the effect of monetary policy on a large number of variables
Summary
The effect of monetary policy on prices and output is traditionally analysed in vector autoregressions (VARs). A counter-intuitive result emerging in these VARs is that prices tend to increase after a monetary policy tightening; Eichenbaum (1992) referred to this as the price puzzle. The literature has proposed various explanations for this result (for an overview, cf Walsh, 2003, Chapter 1). One is that prices do rise after a monetary policy tightening because there is a cost channel of monetary policy. Another is that the price puzzle is an econometric artefact. A VAR may be misspecified because it does not include all information that is available to the monetary authority
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