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A note on the fed’s power to lower inflation

Abstract

This note argues that the Fed does not have much effect on inflation expectations and that its effect on aggregate demand, and thus on inflation, is modest. Econometric results suggest that a short term interest rate increase of 1.0 percentage point results in a decrease in inflation of 0.43 percentage points after five quarters. The unemployment rate is 0.17 percentage points higher. Therefore, lowering inflation by 2 percentage points, if this is needed, requires about a 4 to 5 percentage point increase in the interest rate, with the full effect taking about five quarters.

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Notes

  1. Some specifications take \(u^*\) to be time varying.

  2. The original tests are in Fair (2000). See (Fair 2021) for the latest results.

  3. “Price level” will be used to describe p even though p is actually the log of the price level.

  4. Each year I give one of my classes an assignment to explain the quarterly log change in the S&P 500 index since 1954 using any set of macro variables they want. Nothing sensible is ever found. There may be some explanatory power in predicting future stock prices or stock returns at long horizons. See, for example, (Greenwood and Shiefer 2014) and references therein. The lack of explanatory power at quarterly frequencies is what is relevant for this paper since it is concerned only with business cycle frequencies.

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Correspondence to Ray C. Fair.

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The baseline forecast from the US model that is used in this note is presented on the website fairmodel.econ.yale.edu. The results in Tables 3 and 4 in this note can be duplicated on the site. Alternative experiments can also be run.

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Fair, R.C. A note on the fed’s power to lower inflation. Bus Econ 57, 56–63 (2022). https://doi.org/10.1057/s11369-022-00254-7

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  • DOI: https://doi.org/10.1057/s11369-022-00254-7