Permanent and Transitory Policy Shocks in an Empirical Macro Model with Asymmetric Information

The estimated actual and perceived target series exhibit considerable time variation
and the difference between the two series can be sizable. In Figure 1, the estimates of
the target and perceived target are predictions conditional on data through the previous
period, but given estimates of model parameters based on the full sample. Movements in
the estimated target reflect the direct contribution of permanent policy shocks to inflation
variability. Thus, the figure suggests that permanent policy shocks that led to shifts in the
implicit inflation target contributed importantly to fluctuations in the perceived target and
inflation. This is a different view than Orphanides and Williams (2003) who assume that
all variation in perceived target shifts is due to learning behavior. The sizable differences
between movements in the actual target and the perceived target provide evidence that
imperfect credibility associated with learning is also an important factor explaining time
variation in the perceived target and inflation. Learning behavior introduces recognition
lags so that movements of the perceived target lag those in the target series.

Also included in Figure 1 is a line reflecting the estimate of the constant target from
the constant model. At 4 percent, the estimated constant target seems high for the recent
period, while values of the estimated time-varying target are plausible. Describing his
preference for an inflation target range, Governor Gramlich (2003) recently commented
that he “would personally set the bottom of the range at slightly above 1 percent per year
for the core PCE deflator, ... and ... the top of the range at about 2.5 percent per year. The
midpoint of this range is then slightly less than 2 percent per year, which turns out to be
about what U.S. core PCE inflation has averaged over the past eight years.” The inflation
goal of U.S. monetary policy is usually described as “price stability,” Governor Bernanke
(2003) provided his view of this concept, noting: “Inflation breached the 2 percent barrier
in the spring of 1996 and has remained consistently within the narrow range of 1.5 to 2
percent for the past six and a half years—for practical purposes, a good approximation to
price stability.”

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