Monetary Policy in Uncertain Times

Simon Smith, Allan Timmermann () and Jonathan Wright
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Allan Timmermann: https://rady.ucsd.edu/faculty-research/faculty/allan-timmermann.html

No 2024-08-30-1, FEDS Notes from Board of Governors of the Federal Reserve System (U.S.)

Abstract: We investigate the effect of uncertainty surrounding the slope of the Phillips curve on optimal monetary policy. To do this, we first account for parameter uncertainty in a time-invariant Bayesian Phillips curve model. Second, we generalize this model to allow for instabilities in the form of breaks. In both the United States (US) and the European Union (EU), we identify a break around the turn of the century, after which the Phillips curve flattened. Finally, we show how breaks amplify uncertainty in the Phillips curve model, significantly impacting optimal monetary policy. Accounting for breaks causes policymakers to respond more cautiously to deviations in the unemployment rate from its natural rate – as they are less certain about the impact of economic slack on inflation – but to compensate for this increased caution by responding more aggressively to deviations of inflation from its target. Our estimates provide a lower bound for the magnitude of the impact of breaks on the change in responsiveness of optimal monetary policy since they are based on the full sample of data, while policymakers face additional uncertainty as they must continuously determine in real time whether a break has occurred.

Date: 2024-08-30
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedgfn:2024-08-30-1

DOI: 10.17016/2380-7172.3603

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