Inflation Persistence and the Taylor Principle

Although the persistence of inflation is a central concern of macroeconomics, there is no consensus regarding whether or not inflation is stationary or has a unit root. We show that, in the context of a “textbook” macroeconomic model, inflation is stationary if and only if the Taylor rule obeys the Taylor principle, so that the real interest rate is increased when inflation rises above the target inflation rate. We estimate Markov switching models for both inflation and real-time forward looking Taylor rules. Inflation appears to have a unit root for most of the 1967 – 1981 period, and is stationary before 1967 and after 1981. We find that the Fed’s response to inflation is also regime dependent, with both the pre and post-Volcker samples containing monetary regimes where the Fed both did and did not follow the Taylor principle. This contrasts to recent research that suggests the Fed’s response to inflation has been time invariant, and that changes in monetary policy only occurred with respect to the output gap.