The Central Bank’s Dilemma: Look Through Supply Shocks or Control Inflation Expectations?

IMF Working Papers, May 15, 2026

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Central banks face a dilemma when hit by supply shocks: either look through the shocks or react to ensure inflation expectations remain anchored.
The paper proposes a tractable framework to capture this dilemma and explores optimal policy under various assumptions on how agents form expectations and how sophisticated those expectations are in accounting for the central bank’s announced policies.
Baseline analysis focuses on level-k thinking (LKT), a form of bounded rationality that encompasses both adaptive expectations (AE) and rational expectations (RE) as special cases.

The optimal policy under LKT is qualitatively very different from its analogues under AE and RE, exhibiting abrupt pivots in policy stance.
It is optimal for the central bank to initially look through supply shocks until a threshold is reached, then pivot discontinuously to a more hawkish anti-inflationary stance.
Such discontinuous pivots can, if optimally executed, be compatible with soft landings in the sense that most (or even all) of the reduction in inflation occurs through re-anchoring of expectations rather than economic slack.
Policy errors in terms of tightening too late or too slowly can be especially costly in this environment.

Presents a tractable framework that allows comparison of optimal policies across different expectation-formation mechanisms and varying sophistication levels about announced policies.
Baseline uses level-k thinking (LKT) due to its empirical support in experimental literature and because it nests AE and RE as special cases.
Shows that boundedly rational expectation formation (LKT) can generate policy dynamics (abrupt pivots) not predicted under AE or RE.

Central banks may optimally "look through" supply shocks initially, but should have a credible plan to pivot to a hawkish stance once a threshold is reached.
Credible, well-timed pivots can re-anchor inflation expectations and allow inflation reductions to occur with limited output slack (supporting soft landings).
Avoiding policy errors—specifically delaying or slowing tightening when required—is crucial because such errors are particularly costly under LKT-type expectation formation.

The strategy of initially looking through shocks requires careful timing; misjudging the threshold or executing the pivot poorly raises the risk of costly inflation dynamics.
The analysis highlights the importance of accounting for bounded rationality and heterogeneity in expectation formation when designing monetary policy.

Subject: Economic theory, Employment, Inflation, Labor, Prices, Supply shocks, Unemployment, Wages
Keywords: announced policy, central bank's dilemma, control inflation expectation, Employment, Global, Inflation, inflation expectation, Inflation expectations, inflation surge, monetary policy, supply shocks, Unemployment, Wages