agents may be misperceived as backward looking behavior. The lag may not be due to
“irrationality” but to asymmetric information on the part of market participants and the
Federal Reserve.
The model decomposes fluctuations in inflation and long-term rates into components
due to natural rate movements and to transitory variation. As discussed earlier, in the
time-varying target model, both permanent policy shocks and effects of learning associated
with imperfect policy credibility contributed importantly to fluctuations in the perceived
inflation target and inflation. Unlike the constant target model, natural rate movements
in the time-varying target model also contribute importantly to fluctuations in long-term
interest rates (Figure 4). Since the natural real rate and the term premium natural rate
are both assumed to be constant, all the variation in the long-rate natural rate comes
from variation in the perceived inflation target. Fluctuations in the long-rate natural
rate are related to the level factor in Kozicki and Tinsley (2001b), Dewachter and Lyrio
(2002), Hordahl, Tristani, and Vestin (2002) and Rudebusch and Wu (2003). Although
quarter-to-quarter fluctuations in the natural rate are generally the same or smaller than
those in long rate deviations, low frequency fluctuations involve swings that are as large.
The main point to take from this chart is that variation in natural rates appears to be
as important in contributing to historical movements in long rates as transitory variations
around natural rates.
4ModelDynamics
This section compares the dynamic properties of the time-varying target model to those of
the constant-target model. The time-varying target model is used also to investigate the
transition to a new inflation rate following a permanent policy shock to the inflation target
and to examine behavior following an expectations shock, i.e., a shock to the perceived
target.
22
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