Following the leader? The relevance of the Fed funds rate for inflation targeting countries

Abstract

In a New-Keynesian model for a small open economy, we derive a CPI inflation-based Taylor rule that implements the flexible price allocation. We conclude that, in this rule, the natural rate of interest should be linked to the foreign interest rate and to domestic productivity shocks. This rule ensures that the CPI real rate moves in order to induce movements in consumption that are coherent with the flexible price allocation. The empirical evidence shows that inflation-targeting central banks respond to movements in the Fed funds rate, besides reacting to expected CPI inflation and to the domestic output gap. This is true for developed and emerging economies. Furthermore, we find that in emerging countries the response to foreign variables is not different from zero, as suggested by theory, when domestic inflation, rather than CPI inflation, is introduced in the policy rule.