Changes in the Inflation Target and the Comovement Between Inflation and the Nominal Interest Rate1

Abstract

Would raising the inflation target require an increase in the nominal interest rate in the short run? We answer this policy question, first analytically in a small-scale New Keynesian model with backward-looking components where a closed-form solution exists, and then, in a medium-scale Smets and Wouters model calibrated to the US economy. Our analysis shows that the short-run comovement between inflation and the nominal interest rate conditional on changes in the inflation target is more likely to be positive, all else equal, as the monetary authority reacts less aggressively to the deviation of inflation from its target. Meanwhile, features of the model that enhance backward-looking behaviour, such as backward price indexation and habit formation in consumption, are shown to reduce the likelihood of the positive comovement. However, our investigations reveal that in both models, this positive comovement or the so-called Neo-Fisherism is prevalent across a wide range of empirically plausible parameter values. Using the Smets and Wouters model with a zero lower bound (ZLB) constraint on the nominal interest rate, we show that raising the inflation target could be an effective alternative policy framework to reduce the possibility of a binding ZLB constraint and to mitigate the potentially large output loss.