DP9824 | Monetary Policy Surprises, Credit Costs and Economic Activity

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We provide evidence on the nature of the monetary policy transmission mechanism. To identify policy shocks in a setting with both economic and financial variables, we combine traditional monetary vector autoregression (VAR) analysis with high frequency identification (HFI) of monetary policy shocks. We first show that the shocks identified using HFI surprises as external instruments produce responses in output and inflation consistent with those obtained in the standard monetary VAR analysis. We also find, however, that monetary policy responses typically produce ?modest? movements in short rates that lead to ?large? movements in credit costs and economic activity. The large movements in credit costs are mainly due to the reaction of both term premia and credit spreads that are typically absent from the baseline model of monetary transmission. Finally, we show that forward guidance is important to the overall strength of policy transmission.