Effects of Interest Rate Policy on Inflation

Abstract

This paper analyzes the episodes of high inflation and the efficacy of raising interest rates in reducing inflationary pressures in the U.S. economy. Estimating a Markov-switching regression model, the results show that high inflation frequently occurred from 1975 to 1983 with the most prolonged duration. In the 2000s, there were merely two inflationary months in 2008, but this is too short to call it a period. Then, after a period of low inflation in 2020, inflationary pressure started to build up. From March 2021 to the present, a period of high inflation has been prevailing. The estimation results suggest that the period from 1976 to 1983 is one episode of the high inflation period, and the period from 2016 to 2022 is the second period, which is about equal in length to both periods. A simple sub-period analysis shows that an increase in the federal funds rate lowers future inflation in both periods. A vector autoregression model is then estimated to identify the monetary policy channel via the short-term interest rate together with other variables such as inflation expectations and real economic activity. A one standard deviation increase in the federal funds rate can reduce annual inflation by up to 1.6 percent in the first period and 0.74 percent in the second. The effects on expected inflation are also comparable. The results suggest that interest rate policy has been effective in controlling inflation.