Benefits of gradualism or costs of inaction? Monetary policy in a time of uncertainty

Should monetary policy be more aggressive or more cautious when facing uncertainty regarding the relationship between macroeconomic variables? This paper’s answer is: “it depends” on the degree of persistence of the shocks that hit the economy. The paper studies optimal monetary policy in a basic (two-equation) forward-looking New-Keynesian (NK) framework with random parameters. It relaxes the assumption of full central bank information in two ways: allowing for uncertainty on model parameters and asymmetric information. While the private sector fully observes the realizations of the random process of the parameters as they occur, the central bank observes them with a one quarter delay. Compared to the problem with full information, the monetary authority must solve the Bayesian decision problem of minimizing the expected stream of future welfare losses integrating over his prior probability distribution of the unknown parameters. The paper proposes a general method to account for uncertainty on any subset of parameters of the model. As an application, it focuses on two cases: uncertainty on the natural rate of interest and uncertainty on the slope of the Phillips curve.

Uncertainty about the slope of the PC reduces welfare for a risk averse central banker. The larger is uncertainty, the higher the probability that aggressive monetary policy responses to shocks move inflation and output away from targets, thus the larger the expected welfare costs. Abstracting from expectations about the future, the Brainard principle would apply: cautiousness in response to cost-push shocks would reduce welfare losses. However, rational agents anticipate that monetary policy inaction would also imply deviations of inflation and output gap from the target in the future. As current endogenous variables depend on expectations, the effects of inaction in the face of uncertainty would be amplified. The more persistent are the shocks, the larger the effect of inaction on expectations and the cost in terms of welfare. There is a threshold value of persistence of cost-push shocks at which gains and losses from being cautious offset each other. Beyond that threshold, losses from inaction would outweigh current gains, so that it pays for monetary policy to be more aggressive. Below that threshold, it pays to be more cautious.