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Estimating the Revealed Inflation Target: An Application to U.S. Monetary Policy

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  • Daniel Leigh

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    (European International Monetary Fund)

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    Abstract

    This paper proposes a new method of estimating the Taylor rule with a time-varying implicit inflation target and a time-varying natural rate of interest. The inflation target and the natural rate are modelled as random walks and are estimated using maximum likelihood and the Kalman filter. I apply this method to U.S. monetary policy over the last 25 years to understand how the Federal Reserve’s target has varied during this broadly successful period. Stability tests indicate significant time variation in the implicit target. In the early 1980s, during the Volcker disinflation, the inflation target is near 3%. In the late 1980s and early 1990s, the target is close to actual inflation of 3-4% and only declines once the 1990-91 recession reduces inflation to 1-2%, corroborating historical evidence of an “opportunistic approach to disinflation.†Finally, over 2001-2004, the target rises to 2-3%, behaviour that can be interpreted as a response the risks of hitting the zero bound on nominal interest rates

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    File URL: http://repec.org/sce2005/up.10807.1106941375.pdf
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    Bibliographic Info

    Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2005 with number 177.

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    Date of creation: 11 Nov 2005
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    Handle: RePEc:sce:scecf5:177

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    Keywords: Taylor rule; time-varying parameters; Kalman filter;

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    1. Jane Haltmaier, 2001. "The use of cyclical indicators in estimating the output gap in Japan," International Finance Discussion Papers 701, Board of Governors of the Federal Reserve System (U.S.).
    2. Thomas Lubik & Frank Schorfheide, 2002. "Testing for Indeterminacy:An Application to U.S. Monetary Policy," Economics Working Paper Archive 480, The Johns Hopkins University,Department of Economics, revised Jun 2003.
    3. Thomas Laubach & John C. Williams, 2001. "Measuring the natural rate of interest," Finance and Economics Discussion Series 2001-56, Board of Governors of the Federal Reserve System (U.S.).
    4. Athanasios Orphanides & David W. Wilcox, 1996. "The opportunistic approach to disinflation," Finance and Economics Discussion Series 96-24, Board of Governors of the Federal Reserve System (U.S.).
    5. repec:fip:fedgsq:y:2002:i:nov21 is not listed on IDEAS
    6. Ben S. Bernanke, 2002. "Deflation: making sure "it" doesn't happen here," Speech 530, Board of Governors of the Federal Reserve System (U.S.).
    7. Douglas Staiger & James H. Stock & Mark W. Watson, 1996. "How Precise are Estimates of the Natural Rate of Unemployment?," NBER Working Papers 5477, National Bureau of Economic Research, Inc.
    8. Athanasios Orphanides, 2003. "Historical monetary policy analysis and the Taylor rule," Finance and Economics Discussion Series 2003-36, Board of Governors of the Federal Reserve System (U.S.).
    9. Gauti B. Eggertsson & Michael Woodford, 2003. "The Zero Bound on Interest Rates and Optimal Monetary Policy," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 34(1), pages 139-235.
    10. Thomas Laubach, 2001. "Measuring The NAIRU: Evidence From Seven Economies," The Review of Economics and Statistics, MIT Press, vol. 83(2), pages 218-231, May.
    11. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1997. "Monetary Policy Rules in Practice: Some International Evidence," CEPR Discussion Papers 1750, C.E.P.R. Discussion Papers.
    12. Ben S. Bernanke & Vincent R. Reinhart, 2004. "Conducting Monetary Policy at Very Low Short-Term Interest Rates," American Economic Review, American Economic Association, vol. 94(2), pages 85-90, May.
    13. Athanasios Orphanides, 1998. "Monetary policy rules based on real-time data," Finance and Economics Discussion Series 1998-03, Board of Governors of the Federal Reserve System (U.S.).
    14. Daniel Leigh, 2004. "Monetary Policy and the Dangers of Deflation:Lessons from Japan," Economics Working Paper Archive 511, The Johns Hopkins University,Department of Economics.
    15. Kenneth N. Kuttner, 2004. "The role of policy rules in inflation targeting," Review, Federal Reserve Bank of St. Louis, issue Jul, pages 89-112.
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