Bias in Local Projections; Ed Herbst (Federal Reserve Board)

Abstract

Local projections (LPs) are a popular tool in macroeconomic research. We show that LPs are often used with very small samples in the time dimension. Consequently, LP point estimates can be severely biased. We derive simple expressions for this bias and propose a way to bias-correct LPs. Small sample bias can also lead autocorrelation robust standard errors to dramatically understate sampling uncertainty. We argue they should be avoided in LPs like the ones we study. Using identified monetary policy shocks, we demonstrate that the bias in point estimates can be economically meaningful and the bias in standard errors can affect inference.

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