rate are due to transitory policy shocks or to permanent policy shocks that change the
inflation target. Deviations between the estimated actual and perceived target provide
evidence of asymmetric information on the part of private sector agents about the inflation
goal of monetary policy. The results suggest that time-varying natural rates associated
with movements in the perceived inflation target contributed importantly to historical
fluctuations in inflation and long-term interest rates. Both permanent policy shocks and
learning associated with imperfect policy credibility explain movements in the perceived
inflation target.
In the perpetual learning model of the inflation target, the perceived inflation target
is adjusted to reflect deviations of funds rate settings from predictions conditioned on the
perceived inflation target. Although the estimated speed of learning is quite slow—with only
4 percent of the gap between the target and the perceived target closed per quarter—implied
model dynamics and interactions between variables appeared reasonable. Learning behavior
implies lengthy lags between movements in the actual inflation target and the perceived
inflation target. The estimated perceived inflation target tracks movements in long-horizon
survey expectations of inflation quite well. Important dynamic features of the model are
the absence of a price puzzle in the response to a transitory policy shock and permanent
nominal effects of aggregate supply shocks due to partial policy accommodation. In contrast
to standard VARs, the specification can be used to examine the dynamic responses to a
permanent change in the inflation target and to expectations shocks.
Finally, the paper uses simulations to show that faster learning associated with increased
credibility could shorten the transition period to a new inflation target, and reduce the real
effects associated with such a policy change. However, faster learning also implies greater
volatility in response to transitory policy shocks.
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