The Great Moderation and the ‘Bernanke Conjecture’

Was the Great Moderation in the United States due to good policy or good luck? Taking, as data generation process, a New Keynesian sticky-price model in which the only source of change is the move from a passive to an active monetary rule, we show how standard econometric methods, both reducedform and structural, often misinterpret good policy for good luck. Specifically, we show how such a move is perfectly compatible with: (a) little change in the estimated impulse-response functions to a monetary policy shock, as in Stock and Watson (2002), Primiceri (2005), Canova and Gambetti (2005), and Gambetti, Pappa, and Canova (2006). (b) Significant changes in the estimated volatilities of both reduced-form and structural shocks–as in (e.g.) Ahmed, Levin, and Wilson (2004) and Stock and Watson (2002)–even in the absence, by construction, of any change in the volatilities of structural innovations. (c) Little change in the integrated normalised spectra of inflation and GDP growth at the business-cycle frequencies, as in Ahmed, Levin, and Wilson (2004). In line with Bernanke’s (2004) conjecture, the explanation is that conventional econometric methods are intrinsically incapable of capturing the role played by the systematic component of monetary policy in (de)stabilising in- flation expectations, and are therefore inevitably bound to confuse shifts in expected inflation with true structural innovations, thus giving the illusion of good luck even when good policy is, by construction, the authentic explanation