Monetary Policy with Uncertain Inflation Persistence

IMF Working Papers, March 8, 2024

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When uncertain about inflation persistence, central banks are well-advised to adopt a robust strategy when setting interest rates.
The robust approach is characterized by a "better safe than sorry" philosophy and entails incurring a modest cost to safeguard against a protracted period of deviating inflation.
Applied to the post-pandemic period of exceptional uncertainty and elevated inflation, this strategy would have called for a tightening bias.
A high level of uncertainty surrounding wage, profit, and price dynamics requires a more front-loaded increase in interest rates compared to a baseline scenario in which the policymaker fully understands how shocks to those variables are transmitted to inflation and output.
The paper provides empirical evidence of such uncertainty.

Estimates a New Keynesian Dynamic Stochastic General Equilibrium (DSGE) model for the euro area.
Uses the estimated DSGE model to derive a robust interest rate path for the ECB to illustrate insuring against inflation turning out to have greater persistence.

Adopt a robust (insurance) interest-rate strategy under uncertain inflation persistence.
Favor a tightening bias—more front-loaded increases in interest rates—when uncertainty about wage, profit, and price dynamics is high.
Accept a modest short-term cost as insurance against a protracted deviation of inflation from target.