The Consequences of Falling Behind the Curve: Inflation Shocks and Policy Delays Under Rational and Behavioral Expectations

IMF Working Papers, March 1, 2024

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Central banks in major industrialized economies were slow to react to the surge in inflation that began in early 2021.
Proximate causes of the inflation surge:
- supply chain disruptions associated with the easing of COVID restrictions,
- fiscal policies designed to cushion the economic impact of COVID,
- impact on commodity prices and supply chains of the war in Ukraine.

Policy delay worsens inflation outcomes.
Policy delay can mitigate or even reverse the output decline that occurs when policy responds without delay.

Loss is monotonically increasing in the length of the delay.
Loss is reduced if policy, when it does react, is more aggressive.
Two measures of loss are used that incorporate a “balanced approach” to weigh inflation and the output gap.

Rational expectations baseline is compared with a behavioral alternative: cognitive discounting.
With cognitive discounting:
- forward guidance is less powerful,
- the costs of delay are reduced relative to the rational expectations case.
Under either expectations assumption, the costs of a short delay can be eliminated by:
- adopting a less inertial policy rule,
- adopting a more aggressive response to inflation.

Short delays need not be costly if monetary policy rules are adjusted to be less inertial and more aggressive against inflation when policy is resumed.
Stronger policy responses when action is taken reduce the loss associated with earlier inaction.
Consideration of behavioral expectations (cognitive discounting) implies smaller gains from forward guidance and lower costs of delay, affecting the assessment of optimal timing and communication strategies.