Monetary Policy with Uncertain Inflation Persistence
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Summary:
When uncertain about inflation persistence, central banks are well-advised to adopt a robust strategy when setting interest rates. This robust approach, characterized by a "better safe than sorry" philosophy, entails incurring a modest cost to safeguard against a protracted period of deviating inflation. Applied to the post-pandemic period of exceptional uncertainty and elevated inflation, this strategy would have called for a tightening bias. Specifically, a high level of uncertainty surrounding wage, profit, and price dynamics requires a more front-loaded increase in interest rates compared to a baseline scenario which the policymaker fully understands how shocks to those variables are transmitted to inflation and output. This paper provides empirical evidence of such uncertainty and estimates a New Keynesian Dynamic Stochastic General Equilibrium (DSGE) model for the euro area to derive a robust interest rate path for the ECB which serves to illustrate the case for insuring against inflation turning out to have greater persistence.
Series:
Working Paper No. 2024/047
Subject:
Central bank policy rate Financial services Inflation Inflation persistence Labor Output gap Prices Production Wages
Frequency:
regular
English
Publication Date:
March 8, 2024
ISBN/ISSN:
9798400269394/1018-5941
Stock No:
WPIEA2024047
Format:
Paper
Pages:
32
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