Rational Expectations, Long-run Taylor Rule, and Forecasting Inflation

Abstract

The rational expectations model implies that nominal interest

rates reflect expectations of inflation, and thus the term

structure of interest rates provides information on the future

change in inflation. However, the monetary authority

manipulates the short-term interest rate in response to the

change in the price level, and accordingly the prediction of

inflation cannot be separated from the monetary policy. This

paper explores the linkage between the monetary policy rules

and the prediction of inflation. The prediction of inflation can be

influenced by the monetary policy rules if the Fed reacts

strongly to inflation. Using the long-run Taylor rule, an

assessment of the prediction performance regarding future

change in inflation is provided. The empirical results indicate

that the long-run Taylor rule improves forecasting accuracy.