How Costly Will Reining in Inflation Be? It Depends on How Rational We Are

IMF Working Papers, February 3, 2023

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Past highly inflationary episodes are often characterized by a steeper inflation–slack relationship.
Model-generated data from a standard small Dynamic Stochastic General Equilibrium (DSGE) model can replicate this empirical finding when estimated with different expectation formation processes.
When inflation becomes de-anchored and expectations drift, high inflation can occur even with a mildly positive output gap in response to cost-push shocks.
An unconditioned (not controlling for expectations change) Phillips curve estimated in normal times should not be used to predict the cost of reining in inflation.
Optimal policy exercises prescribe early monetary policy tightening and then easing in the context of positive output gaps and inflation far above the central bank target.

Framework: standard small DSGE model.
Estimation: model-generated data estimated under different expectation formation processes (including expectation drift).
Empirical focus: characterizing inflation–slack (inflation–output gap) relationship across past highly inflationary episodes.
Key modeling insight: expectation formation critically alters the slope of the inflation–slack relationship and the observed inflation response to cost-push shocks.

Do not rely on Phillips curves estimated in normal times without conditioning for changes in expectations when forecasting the output cost of reducing inflation.
Adopt early monetary policy tightening when inflation is de-anchored and expectations are drifting.
After initial tightening, consider easing policy even if output gaps remain positive, when inflation is far above the central bank target, as indicated by optimal policy exercises in the study.