Estimates of the target series, the real federal funds rate, and inflation are shown in
Figure 2. The implicit target follows the same general low frequency movements observed
in inflation and is similar to the “core” inflation series estimated by Cogley and Sargent
(2003) and to the probability of a high inflation regime under asymmetric information
in Schorfheide (2003).6 As would be expected, movements in the target generally lead
movements in inflation. One exception to this leading property is the rapid rise in inflation
in the mid-1970 that followed the first oil price shock. One interpretation is that the large
increase in inflation at that time was a consequence of a negative supply shock and not due
to a change in the inflation target. The subsequent increase in the estimated implicit target
may then be interpreted as partial accommodation of the effects of the supply shock on
inflation due to a reluctance on the part of the central bank to tighten policy as necessary
to reverse this increase. This view is consistent with Bernanke (2003) who commented
that “without Fed accommodation, higher oil prices abroad would not have translated into
domestic inflation to any significant degree.”
Also apparent in Figure 2 is a strong negative relationship between the real funds rate
and the estimated implicit target. During the 1960s, the real funds rate fluctuated around
about 2 percent and the estimated target inched upward. The target rose more rapidly
in the late 1960s with the fall in the real funds rate. Subsequently, the negative real rates
observed in the mid to late 1970s suggest that the Fed may have been willing to accept higher
inflation. This policy shows up as a relatively high implicit inflation target. The policy was
rapidly reversed with the Volker tightening. In the early 1980s a sizable reduction in the
estimated implicit target is accompanied by a rapid rise in the real funds rate. Although
the implicit target remained close to 4 percent through the “credit crunch” of the early
1990s, it has since fallen further.
6The probability of a high inflation regime under asymmetric information in Schorfheide (2003) increases
somewhat later than the rise in the core inflation series of Cogley and Sargent (2003) and the increase in
the inflation target estimated in the current paper.
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