Tolerable Inflation, Intolerable Uncertainty

Eric Vansteenberghe

Papers from arXiv.org

Abstract: Numerical inflation targets anchor beliefs. Across euro-area and US professional forecasts, inflation swaps and options, and realized inflation, uncertainty about inflation is compressed at the announced number and kinks exactly there. This paper identifies a cost of the same design that, to our knowledge, has not been shown before, and that appears in second moments only. Within the workhorse New Keynesian model, tolerating part of the inflation a supply shock produces is optimal, yet the optimal tolerated share is not identified: optimal look-through and an unwarranted drift of the effective target are observationally equivalent in the inflation history, so a central bank cannot demonstrate that a warranted deviation is warranted, ex post as much as in real time. Agents holding finite, heterogeneous patience then generate predictive variance that is flat below the target and rises linearly with the expected overshoot above it -- an observational-equivalence bill, zero at the announced number and accumulating with the point-years inflation spends above it. The first-order benefit of the number stands; what the cost changes is how inflation uncertainty must be measured. The distance from target explains 70% of the variation in professional forecast variance, and the bill lies within that component; Normalized Uncertainty -- to our knowledge the first such correction -- removes it. The purge changes inference substantially: on French loan-level data, raw dispersion is unrelated to corporate loan rates, while one standard deviation of the purged measure is associated with rates 89 basis points higher, and cross-country growth and time-series results shift similarly. Conventional measures of inflation uncertainty partly record inflation's distance from its anchor rather than uncertainty about the outlook.

Date: 2026-09
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