4Q Assuming the central bank does respond and that its reaction function is well approximated by the Taylor Rule, how will this alter Grant’s expectations regarding the paths of growth, inflation, and short-term rates over the next five years ？
4A
If the central bank responds as expected, it will push short-term rates down farther and faster than they would otherwise fall in an effort to mitigate the downward momentum of growth and inflation.
If the central bank correctly calibrates its policy, growth and inflation should decline less, bottom out sooner, and recover more quickly toward trend growth and the target inflation level, respectively, than in the absence of a policy response.
Whereas the central bank is virtually certain to drive short rates down farther and faster, it may be inclined to let the market dictate the pace at which rates eventually rise.
That is, it may simply “accommodate” the need for higher rates rather than risk unduly restraining the recovery once it is established.
