Identify the Federal Reserve’s off-equilibrium inflation response

Identify the Federal Reserve’s response to inflation on off-equilibrium paths, rather than merely estimating the on-equilibrium correlation between policy rates and observed inflation.

Background

In the baseline New Keynesian model, the Taylor-principle response concerns what the central bank would do if inflation deviated from the equilibrium path. Under determinacy, however, inflation adjusts so that the relevant accelerating-inflation path is not observed. Equilibrium regressions can therefore recover the persistence of a disturbance rather than the policy coefficient itself.

Alternative studies restore identification only by imposing additional restrictions on the policy rule, private-sector persistence, or the shock process. The paper concludes that these assumptions are not supplied by equilibrium time-series data alone.