Higher Order Interest-Smoothing, Time-Varying Inflation Target and the Prospect of Indeterminacy

Single equation estimation highlights the importance of higher order interest rate smoothing in explaining interest rate inertia. We provide evidence conditioned on a Bayesian model consistent approach showing that higher order interest rate smoothing is empirically relevant and has important implications for the prospect of determinacy. Based on an estimated New Keynesian model with positive trend inflation allowing the joint possibility of determinacy and indeterminacy, we find the preferred interest rate rule characterizing the Fed’s behavior includes second order interest-smoothing, a time-varying inflation target, a response to output growth, and a persistent policy shock. This is true for the pre-Volcker era and Great Moderation. Importantly, our evidence suggests this rule avoided self-fulfilling revisions in inflationary expectations and indeterminacy during the pre-Volcker years. Including an observable for the inflation target in the estimation is a key factor leading to these findings.