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.