Uncertainty and Monetary Policy in the US: A Journey into Non-Linear Territory

This paper estimates a non-linear Interacted VAR model to assess whether the real effects of stimulative monetary policy shocks are milder during times of high uncertainty. Crucially, uncertainty is modeled endogenously in the VAR, thus allowing to take account of two unexplored channels of monetary policy transmission working through uncertainty mitigation and uncertainty mean reversion. Generalized Impulse Response Functions à la Koop, Pesaran and Potter (1996) reveal that monetary policy shocks are significantly less powerful during uncertain times, the peak reactions of a battery of real variables being about two-thirds milder than those during tranquil times. Failing to account for endogenous uncertainty would bias responses and imply twice as powerful monetary policy during uncertain times as during tranquil times, mainly because of the non-consideration of uncertainty mean reversion.