Did the Fed Act Gradually?
Estimating Changes in
Inflation Pressure
in Real Time
Pierre L. Siklos, WLU
Diana N. Weymark, Vanderbilt
Motivation
Focus
Vintages Examined so far




August 1998
May 2002
November 2002
May 2004


Full sample: 1970-end of vintage
Sub-sample: 1980- end of vintage
What is Inflation Pressure? I
What is Inflation Pressure? II
The Ups and Downs
of the fed funds rate

The 2004-2005 period is especially interesting
because of the ‘conundrum’ (rotating yield curve;
Backus and Wright 2007)


Inflation was also generally held in check
Other episodes?



Jan 2001- June 2003 easing: 70% of reductions were 5obp
at a time.
June 1989 – Sept 1992: 25bp cuts 90% of the time
1994-95, 1999-2000, 2004-06 tightening usually involved
25bp rises, with 50bp increases infrequent
1/1/1983
1/1/1984
1/1/1985
1/1/1986
1/1/1987
1/1/1988
1/1/1989
1/1/1990
1/1/1991
1/1/1992
1/1/1993
1/1/1994
1/1/1995
1/1/1996
1/1/1997
1/1/1998
1/1/1999
1/1/2000
1/1/2001
1/1/2002
1/1/2003
1/1/2004
1/1/2005
1/1/2006
1/1/2007
Percent
Target Fed funds rate I
12
10
8
6
4
2
0
1/
1/
1/
00
4
03
20
02
20
01
20
1/
2
1/
1/
1/
99
00
19
20
1/
1/
1/
1/
1/
Percent
Target Fed funds rate: II
7
6
5
4
3
2
1
0
Measuring the Impact of Monetary
Policy
Measuring the Impact of Monetary
Policy
Introducing Measures of
Inflation Pressure
BUT….
Counterfactual Experiments are
Needed
Methodology: Outline
The Model for the US Economy
yt  1[it  Et  t 1 ]   2 Et yt 1  ut
 t  1 Et  t 1   2  t 1   3 ~yt  et
it   0   it 1  (1   )[  Et  t  m   y Et yt  n ]  t
m, n  0
Solving the Model

Conjecture a solution & solve using TR
yt  1 ut  2 et  3 it 1
 t  1 ut   2 et   3 it 1
Solving the Model: I
Solving the Model: II
Solving the Model: III
Solving the Model: EAIP
Ex Post IP (EPIP): I
EPIP: II
Indicators
of Monetary Policy: I

PIIPt





=0  No change in IP
=1  Inflation held
constant
<0  MP underreacts to
IP (actually raises it)
> 1  MP ‘overshoots’*
 *opposite sign
0<PIIP<1  MP reduces
some IP
PIIPt 
 ti 0   t
t
EAIPt
 t
 1
EAIPt
Indicators
of Monetary Policy: II

MPEt





=1  MP completely
effective
=0  MP ineffective or
‘neutral’
<0  MP unsuccessful
 IP maginfied
> 1  MP ‘overshoots’*
 *opposite sign
0<MPE<1  MP
partially effective
EPIPt
MPEt  1 
EAIPt
Measuring IP
with Quarterly Data




There is a ‘control’ lag between the interest rate and
inflation
Therefore IP is the inflation observed at time t if the
interest rate at time t-1 (or t, t-2, depending on the
lag structure) had been held constant at its t-2 level
Interest rates in other periods generated by the
policy maker’s TR
IP captures the impact on inflation of a one-period
deviation from the TR
US Real Time Data




Federal Reserve Bank of Philadelphia RealTime Data Set
Interest rates and consumer prices are from
the Federal Reserve Bank of St. Louis’ FRED
II
The real interest rate: Greenbook, SPF,
UMich survey, Economist, Consensus
Output Gap: H-P filter & CBO estimates
Inflation Rates
14
12
Percent
10
8
6
4
2
0
197 0
197 5
CPI
1980
1985
1990
Pers Cons Exp
1995
2000
2005
Implicit Price deflator
Real Interest Rates
16
Percent
12
8
4
0
-4
197 0
197 5
1980
1985
1990
Greenbook
SPF
Average one year ahead inflation
1995
2000
2005
University of Michigan
Consensus
Output gap: final revised
.04
.02
.00
-.02
-.04
-.06
-.08
-.1 0
1 97 0
1 97 5
1 980
1 985
H-P filter
1 990
1 995
CBO estimates
2000
Illustration of
Model Estimates
Ex Ante IP: I
24
Ex ante Level of Inflation
20
16
12
8
4
0
1 97 0
1 97 5
1 980
1998 08
2002 11
1 985
1 990
1998 08
2002 05
1 995
2000
2004 05
2005
Ex Ante IP: II
24
20
Percent
16
12
8
4
0
1980
1 9 85
1990
1 995
Ex ante inflation Pressure: full sample
Actual inflation
Ex ante inflation Pressure: sub sample
PIIP: Post 1980 Sample
.35
Policy Induced Inflation Pressure
.30
.25
.20
.1 5
.1 0
.05
.00
-.05
80
82
84
86
88
May 2002
August 1998
90
92
94
May 2004
November 2002
96
98
MPE: Post 1980 sample
Monetary Policy Effectiveness Indicator
1 .0
0.8
0.6
0.4
0.2
0.0
-0.2
1 97 0
1 97 5
1 980
08 1998
05 2004
1 985
1 990
11 2002
05 2002
1 995
2000
08 1998
2005
Conclusions


The Fed may have acted gradually simply because it was largely
successful in influencing expectations of future inflation
The Fed was not always conducting a successful monetary policy





November 2002: MP was clearly unsuccessful since inflationary pressure ex
post was higher than ex ante
Nevertheless, a sharp turnaround took place by the time of the May 2004
vintage
The biggest impact on monetary policy performance occurs not because
the Fed changes its policy rate but via the changes in inflationary
expectations these changes promote
Our results not only reinforce the dramatic revisions in our assessment
of the conduct of monetary policy based on real time data
Models that evaluate policies based on data that stretch back before
1980 must allow for the fact that a notable structural shift