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What Does the Yield Curve Tell Us About the Federal Reserve's Implicit Inflation Target? By Taeyoung Doh |
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Abstract This paper uses a dynamic stochastic general equilibrium (DSGE) model to explore the additional information from the yield curve about the Federal Reserve’s implicit inflation target. In the model, monetary policy follows a nominal interest rate rule with a drifting target inflation rate. Three main finding emerge from this study. First, the estimated inflation target using both macro and yield curve data captures a common trend in inflation and nominal interest rates. This common trend is not identified when the model is estimated using only macro data. Second, DSGE models with a drifting inflation target estimated using yield curve data generate long-horizon inflation expectations that are consistent with survey data evidence. Finally, the model estimated with both macro and yield curve data overpredicts inflation during the 1980s when inflation fell rapidly but long-term rates moved down more slowly. Incorporating time-varying volatility into the model alleviates this overprediction of inflation. Adding imperfect information and learning by private agents about inflation target to the model with time-varying volatility makes little difference because agents learn quickly.
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