Monetary Policy and Inflation Scares

IMF Working Papers, December 20, 2024

Source details

A salient feature of the post-COVID inflation surge is that economic activity has remained resilient despite unfavorable supply-side developments.
The authors develop a macroeconomic model with:
- nonlinear price and wage Phillips curves,
- endogenous intrinsic indexation,
- an unobserved components representation of a cost-push shock.
In the model:
- a persistent large adverse supply shock can lead to a persistent inflation surge while output expands if the central bank follows an inflation forecast-based policy rule and abstains from hiking policy rates for some time as it (erroneously) expects inflationary pressures to dissipate quickly.
- a standard linearized formulation of the model cannot account for these observations under identical assumptions.
The nonlinear framework implies:
- the standard prescription of "looking through" supply shocks is a good policy for small shocks when inflation is near the central bank's target,
- but "looking through" may be quite risky when economic activity is strong and large shocks drive inflation well above target.
- the economic costs of "going the last mile" – i.e. a tight stance aimed at returning inflation quickly to target – can be substantial.

Structural features:
- Nonlinear price Phillips curve.
- Nonlinear wage Phillips curve.
- Endogenous intrinsic indexation.
- Unobserved components representation of a cost-push shock.
Mechanism emphasized:
- Inflation forecast-based policy rules can lead to delayed policy tightening if the central bank expects inflationary pressures to dissipate, permitting a scenario of rising inflation concurrent with expanding output following a large adverse supply shock.
Comparative modeling insight:
- The nonlinear specification is necessary to reproduce the combination of resilient output and persistent inflation observed post-COVID; an otherwise identical linearized model fails to generate these dynamics.

"Looking through" supply shocks:
- Appropriate for small supply shocks when inflation is near the central bank's target.
- Potentially risky when shocks are large and economic activity is strong and inflation is well above target.
"Going the last mile":
- A policy of deliberately tightening to return inflation quickly to target can entail substantial economic costs according to the model.
Policy design consideration:
- Central banks relying on inflation forecast-based rules should be aware that persistent large adverse supply shocks can produce sustained inflationary episodes if policy makers expect rapid dissipation of inflation pressures.

Title: Monetary Policy and Inflation Scares
Authors: Christopher J. Erceg, Jesper Lindé, Mathias Trabandt
Date: December 20, 2024
Series: Working Paper No. 2024/260
Issue: 260
Volume: 2024
Pages: 66
DOI: https://doi.org/10.5089/9798400295287.001
Stock No: WPIEA2024260
ISBN: 9798400295287
ISSN: 1018-5941
Subject keywords: Central bank policy rate, cost-push shock, COVID inflation surge, Inflation, Inflation Dynamics, Inflation Risk, Inflation targeting, Labor markets, Linearized Model, Monetary Policy, New Keynesian Model, Nonlinear Model, policy rule, State-Dependent Pricing, Supply shocks

IMF Working Paper — Monetary Policy and Inflation Scares (Working Paper No. 2024/260), December 20, 2024.