Board of Governors of the Federal Reserve System

January 03, 2023

The SNB-FRB-BIS High-Level Conference on Inflation Risk and Uncertainty

Danilo Cascaldi-Garcia, Juan M. Londono, and Beth Anne Wilson

"Uncertainty is not just an important feature of the monetary policy landscape;

it is the defining characteristic of that landscape."

Alan Greenspan¹

Uncertainty about inflation has risen considerably across the globe since the start of the COVID-19 pandemic. Lack of clarity about how far inflation might fall during the depths of the pandemic gave way to concerns about inflationary pressures as demand surged and supply was constrained throughout 2021. In 2022, the war in Ukraine and extreme weather further boosted already rising inflation and increased uncertainty about how high global inflation would get and for how long the high inflation would persist. These developments pose major challenges for households, businesses, market participants, and policymakers, as inflation is a key concern for all economic agents. To discuss these challenges, the Swiss National Bank (SNB), the Bank for International Settlements (BIS), and the Division of International Finance of the Federal Reserve Board (FRB) jointly organized the second High-Level Conference on Global Risk, Uncertainty, and Volatility on November 8 and 9 of 2022. The conference brought academics and policymakers together to discuss inflation risks, their drivers, and how they propagate to the real economy and to financial markets, and the extent to which policymakers can respond to these challenges.²

Several key insights emerged from the event. First, inflation uncertainty is multi-dimensional and includes uncertainty about the underlying process of aggregate inflation, the behavior of the components that drive aggregate inflation, the myriad shocks that affect inflation, the uncertainty perceived by policymakers, and the course of policy responses to tame inflationary pressures. Second, there are multiple ways to measure inflation uncertainty, and these measures differ in terms of the specific concept being measured, the methodology, and the data used to construct them. Third, for institutions on the front lines of addressing inflationary pressures, the current uncertain situation has required both outside-the-box thinking and the use of information from new and alternative data sources. Fourth, policymakers across the world have different approaches to deal with inflation uncertainty, which range from mitigating risks to insuring against fluctuations. These differences are, in part, related to their historical experiences with inflation. While many emerging market economies (EMEs) have experienced severe episodes of high inflation and inflation uncertainty, for most advanced economies, the last three decades have been ones of low and stable inflation. This is particularly true for Japan, even since the beginning of the pandemic. Finally, the duration of the most recent episode of high inflation that began in 2021 coupled with elevated uncertainty can pose several challenges, especially for policymakers, who might need to react more immediately and aggressively than in the past, thereby increasing the volatility of policy rates.

In his opening remarks of the conference, Thomas Jordan, Chairman of the Governing Board of the SNB, highlighted the importance of three key principles for making monetary policy decisions under a scenario of high uncertainty and upside risks to inflation that limits the reliability of forecasts: pragmatism, consistency, and determination. Pragmatism refers to the ability to adopt policies that are robust to changing conditions and that produce "reasonably good results in a sufficiently large variety of scenarios." Such pragmatic policies do not require following strict rules that are optimal only under a specific model or set of circumstances. Decision making should also be consistent over time to signal a firm commitment to the objective of price stability. Tacit in this principle is that a clear articulation and unwavering commitment to a policy goal will help reduce uncertainty generated by policymakers. Finally, high uncertainty does not always call for caution. Managing certain kinds of risk may call for determination and decisive actions to "provide insurance against particularly bad, though unlikely, events."³

John C. Williams, President and Chief Executive Officer of the Federal Reserve Bank of New York, in a policy keynote talk titled "A Steady Anchor in a Stormy Sea," also highlighted the importance of committing to an explicit longer-run inflation goal, in line with the principles of consistency and determination introduced by Mr. Jordan. He focused on the critical role of inflation expectations in containing inflation and articulated the following three criteria that are important features of well-anchored inflation expectations: sensitivity, level, and uncertainty. The sensitivity criterion refers to the fact that, if inflation expectations are well-anchored, long-term inflation expectations should not be affected by transitory economic shocks. The level criterion refers to the condition that not only are longer-run inflation expectations invariant to shocks, but they are anchored at a specific rate, namely the central bank's long-run inflation target, even when maintaining this level implies a short-run tradeoff with economic activity. Finally, the uncertainty criterion refers to the relation between uncertainty about inflation and the forecast horizon; specifically, about how uncertainty about future inflation must increase less than linearly with the forecast horizon. More simply put, if inflation expectations are well-anchored around a particular rate in the longer run, then that should put some bound on the amount of uncertainty there is about future inflation.⁴

Senior policymakers from several countries discussed their views and experiences with inflation uncertainty in two panels. The first panel, moderated by Andrea Maechler, member of the Governing Board of the SNB, discussed how inflation uncertainty was incorporated into the policymaking process. The panelists reflected on, among other things, whether the elevated post-pandemic uncertainty about inflation was in any sense different from previous sequences of systematically missing inflation forecasts, especially for EMEs that historically experienced elevated levels of inflation and inflation uncertainty. Panelists also discussed how uncertainty about inflation scenarios was considered when making policy decisions. One aspect of this was whether uncertainty about inflation and the inflation process might lead policymakers to discard or down-weight traditional inflation models and rely more on a wide range of traditional and non-traditional data to understand current and future inflation. Overall, the main takeaways of this policy panel were that uncertainty is endemic to monetary policy and that policy making under uncertainty differs across countries depending on several factors, including the country's financial and economic conditions, their historical experiences with inflation and inflation uncertainty, the extent to which they are affected by the post-pandemic high global inflationary episode, and the quality of the data that can inform about the latent level of inflation uncertainty.

The second panel, moderated by Agustin Carstens, General Manager of the BIS, focused on the relation between inflation uncertainty and exchange rate volatility. Although fluctuations in exchange rates are usually considered as part of the adjustment process that results after monetary policy is determined, in the post-pandemic environment of high inflation uncertainty, exchange rate fluctuations became a fundamental part of the problem. There are several reasons for the enhanced role of exchange rate fluctuations, including that the passthrough effect from exchange rates to prices can be higher in a high inflation uncertainty environment. As with policymaking, considerations around exchange rate fluctuations also vary across countries depending on, among other things, the country's exposure to foreign currency debt and the ability and willingness of central banks to intervene to prevent large and undesired exchange rate fluctuations.

The conference featured presentations and discussions of nine academic papers on the topic of inflation uncertainty. These presentations focused on three broad topics. First, several papers introduced new measures of inflation uncertainty using different methodologies and data. All these measures coincide in suggesting that inflation uncertainty spiked up with the large swings in inflation since the beginning of the COVID-19 pandemic. Michael McMahon, from the University of Oxford, and his co-authors, propose text-based measures for policy uncertainty using the text in Federal Open Market Committee (FOMC) deliberation documents. They disentangle different components of uncertainty, namely, uncertainty about inflation, about the real economy, about financial markets, and about economic models. Norbert Metiu, from the Deutsche Bundesbank, and his co-author, propose an econometric-based measure of uncertainty, which is calculated as the conditional volatility of U.S. core inflation. Two of the papers presented use the information in surveys to proxy for inflation uncertainty. Brent Meyer, from the Federal Reserve Bank of Atlanta, and co-authors, propose a measure of inflation expectations based on the aggregation of firm-level unit costs, which is calculated using the Federal Reserve Bank of Atlanta's Business Inflation Expectations Survey. The survey collects subjective probability distributions over own-firm future unit costs from a monthly panel of business executives since October 2011. Philip Bunn, from the Bank of England, and co-authors, draw facts about inflation uncertainty from a large panel business survey in the United Kingdom.

The second main topic is that there is ample empirical evidence suggesting that not just the level of inflation but the uncertainty surrounding it has real and financial effects that are potentially asymmetric, and understanding these effects helps policymakers produce informed responses. The empirical evidence in McMahon and co-authors shows that heightened FOMC members' uncertainty about inflation is skewed towards increasing inflation and, therefore, predicts a more hawkish tilt of policy preferences. Eric Mengus, from HEC Paris, and co-authors, provide novel survey evidence on how households' inflation expectations matter for their spending. The survey evidence indicates that consumption decisions are not a continuously increasing function of inflation expectations, which limits policymakers' ability to manage aggregate demand through the households' inflation expectations channel, therefore leaving limited ammunition for central banks when inflation is high. The evidence in Metiu and co-author suggests that unexpected increases in inflation uncertainty lead to higher output and prices, which is consistent with a demand shift, and that the central bank reacts by tightening the monetary policy. The mechanism behind this positive effect on the business cycle is that higher uncertainty of core inflation feeds into the real economy by raising inflation expectations, leading to higher wages, which, in turn, boost consumer demand and consequently prices and production. However, higher wages would then increase production costs, putting an upward second-round effect on prices and could set off a wage-price spiral.

Third, several papers provided theoretical foundation for the different tools and frameworks that monetary authorities must deal with in the post-pandemic unprecedented high inflation uncertainty environment. Laura Gáti, from the European Central Bank, presented a paper emphasizing the importance of anchoring inflation expectations for the conduct of monetary policy, using a model where the degree of expectations may vary. She finds that optimal policy involves an aggressive interest rate response to any threat of expectations de-anchoring, and that such monetary policy not only stabilizes inflation fluctuations, but also inflation expectations. Chengcheng Jia, from the Federal Reserve Bank of Cleveland, and her co-author, study the implications of the average inflation targeting under time inconsistency and ambiguous information. Average inflation targeting, as any time-dependent policy, is time inconsistent, stemming from the fact that the central bank has an incentive to deviate from it once the private sector is convinced about the targeting. While average inflation targeting is ambiguous about the horizon over which inflation is averaged, this ambiguity and uncertainty about fundamentals help the central bank gain credibility by keeping a fraction of agents believing in average inflation targeting in the long run. Thomas Mertens, from the Federal Reserve Bank of San Francisco, and John Williams, featured evidence of a marked downward trend in the correlation between changes in market-based measures of uncertainty and changes in expected inflation in the United States, and they analyze the theoretical implications of a decline in the natural rate of interest on such declining correlation. Their model indicates the existence of two equilibria: one with inflation at target and the second a liquidity trap. With inflation at target, increased uncertainty implies a higher probability of interest rates hitting the lower bound, creating asymmetric responses to positive and negative economic shocks, resulting in lower mean of expected inflation and interest rates. In the liquidity trap equilibrium, increased uncertainty reduces the probability of hitting the lower bound, resulting in higher mean of expected inflation and interest rates.