Negative Control Identification of Monetary Policy
The present work explores a novel identification method in the setting of monetary policy. This method, called the negative control approach, borrows ideas from the conditional exogeneity and the IV methods but dispenses with the exogeneity assumptions while shifting the focus to the confounding mechanism. An appealing conceptual feature of this model is the fact that endogeneity can be exploited as much as exogeneity. Pioneered in Miao et al. (2018), the approach relies on the use of additional variables and a set of orthogonality conditions to construct a proxy of the endogenous component and block the omitted variable bias. This work is the first application of the negative control approach in the macroeconomic setting. In identifying the causal effects of the market interest rates on the macroeconomic outcomes of interest, we employ macroeconomic news and measures of Fed policy in a novel fashion as the additional variables satisfying orthogonality restrictions derived from the analysis of the information flow. Two key orthogonality conditions are used: (1) macroeconomic news only affects the Fed policy and the market rates by influencing the expectations of the unobserved state of the economy and (2) Fed policy only affects the macroeconomic outcomes through the influence on the market interest rates. A simple state space model supporting the reasoning is presented and the empirical application is benchmarked against the IV approach used in Bauer and Swanson (2023). Resulting estimates support the idea that the improper use of additional observables might underestimate the impact of monetary policy. This work also provides ample ground for further research in expanding the set of auxiliary variables and exploring nonlinear extensions.