Forward-looking information in VAR models and the price puzzle

With a view to addressing the major disadvantage of the VAR model, namely the inadequate description of the central bank reaction function, we propose a VAR specification that proves successful in solving the price puzzle featuring in monetary VARs for the US. This specification consists in augmenting a standard VAR with two forward-looking variables: the federal funds futures rate (or alternatively a money market forward rate) reflecting monetary policy expectations and a composite leading indicator of economic activity. These two variables appear to effectively control for the information set that the Federal Reserve may use in monetary policy decision-making. With this modification, theory-consistent responses to monetary policy shocks are obtained.