Finance and Economics Discussion Series (FEDS)
August 2018
Some Implications of Uncertainty and Misperception for Monetary Policy
Christopher Erceg, James Hebden, Michael T. Kiley, J David Lopez-Salido, and Robert J. Tetlow
Abstract:
When choosing a strategy for monetary policy, policymakers must grapple with mismeasurement of labor market slack, and of the responsiveness of price inflation to that slack. Using stochastic simulations of a small-scale version of the Federal Reserve Board’s principal New Keynesian macroeconomic model, we evaluate representative rule-based policy strategies, paying particular attention to how those strategies interact with initial conditions in the U.S. as they are seen today and with the current outlook. To do this, we construct a current relevant baseline forecast, one that is constructed loosely based on a recent FOMC forecast, and conduct our experiments around that baseline. We find the initial conditions and forecast that policymakers face affect decisions in a material way. The standard advice from the literature, that in the presence of mismeasurement of resource slack policymakers should substantially reduce the weight attached to those measures in setting the policy rate, and substitute toward a more forceful response to inflation, is overstated. We find that a notable response to the unemployment gap is typically beneficial, even if that gap is mismeasured. Even when the dynamics of inflation are governed by a 1970s-style Phillips curve, meaningful response to resource utilization is likely to turn out to be worthwhile, particularly in environments where resource utilization is thought to be tight to begin with and inflation is close to its target level.
Acessible materials (.zip)
Keywords: Monetary policy, uncertainty, stochastic simulation, policy analysis
DOI: https://doi.org/10.17016/FEDS.2018.059
PDF: Full Paper