Estimating the Inflation-Output Variability Frontier with Inflation Targeting: A VAR Approach

This paper (i) illustrates how a VAR model can be used to evaluate inflation targeting, (ii) derives the policy frontier available to the central bank using counterfactual experiments with real time data, and (iii) estimates how this frontier has changed over time in terms of the position and slope of the available tradeoff between output gap variability and inflation variability under inflation targeting. Various inflation targets are considered as are tolerance bands of varying width around these targets. The results indicate that over time (i) a given reduction in inflation variability is associated with a smaller rise in output variability and that (ii) a given inflation variability is achieved with smaller interest rate volatility. Consistent with the data, our results require federal funds rate persistence, though no instrument instability was observed. One interpretation of these results is that they reflect the growing credibility of the Federal Reserve.