How Fed rate moves affect the economy

Alex Verkhivker | Jan 03, 2017

Sections Finance

Collections Monetary Policy

The Federal Reserve and other central banks can move financial markets, but their end goal is actually to influence the real economy. Federal Reserve Bank of Boston’s Ali Ozdagli and Chicago Booth’s Michael Weber find that central-bank policy moves travel to the real economy through production networks.

Economists have long tried modeling the competitive forces that exist within an economy. To do this, they typically use input-output tables that link all the corporate transactions involved in producing a product. Ozdagli and Weber use these benchmark input-output tables—available from the Bureau of Economic Analysis at the US Department of Commerce—to create a network of trade flows that details the movement of money between producers and consumers within the United States for a wide array of goods and industries.

Take cars, for example. When demand increases, car manufacturers buy more inputs such as tires and steering wheels, which in turn causes producers of those inputs to increase production. In this way, demand moves upstream through production networks.

The researchers say that Fed monetary-policy changes have direct demand effects, but also indirect ones through these production networks. Ozdagli and Weber find that 50–80 percent of stock-return swings due to monetary-policy decisions can be attributed to these indirect network effects. “The effect is robust to different sample periods, event windows, and types of announcements,” write the researchers.

The network model of trade flows across producers and consumers is an important mechanism to measure monetary policy’s economic impact on the stock market. Often-cited research by former Fed chair Ben Bernanke and Williams College’s Kenneth Kuttner documents that an unexpected interest-rate cut of 25 basis points leads to a 1 percent return in a broad index of stocks. Ozdagli and Weber help document in their work that production networks help propagate this effect.