Evolving U.S. Monetary Policy and the Decline of Inflation Predictability

Abstract

Using a structural VAR with time-varying parameters and stochastic volatility on post-WWII U.S. data, we document a striking negative correlation between the evolution of the long-run coefficient on inflation in the monetary rule and the evolution of the persistence and predictability of inflation relative to a trend component. Using a standard sticky-price model, we show that a more aggressive policy stance towards inflation causes a decline in inflation predictability, providing a possible interpretation for the findings of the structural VAR.

Keywords: Bayesian time-varying VARs, sign restrictions, frequency domain, Great Inflation, predictability

JEL Classification: E37, E52, E58