How should central banks react to a supply shock?
How should a central bank react when the economy is hit by a supply shock? This is the question Beaudry et al. explore in this paper. To properly address this issue the authors suggest it is important to bring together in the model two key ingredients: “(i) an explicit mechanism for why looking through supply shocks can be attractive to policy-makers under certain circumstances; and (ii) a flexible approach to modeling inflation expectations that allows for the possibility that looking through supply shocks could lead to de-anchoring.” They accomplish this by using a model with:
- Wage rigidity: they consider an economy subject to productivity shocks and assume that wages are set before observing the current shock, while prices are set after. In this case, productivity shocks enter as a residual into the Phillips curve and policy-makers will generally have an incentive to look through these shocks to avoid variation in employment and output.
- Agents’ inflation expectations: Beaudry et al. use a form of bounded rationality namely level-k thinking, a framework that combines both adaptive and rational expectations: the former implies a low level of agents’ sophistication while the latter implies maximum sophistication.
How should central banks react to a supply shock under this framework?
If inflation has been pushed only slightly above target, then policy should mainly look through supply shocks. However, if a series of supply shocks cumulate up to a specific threshold, we showed that policy needs to shift discontinuously to a more hawkish stance in order to control inflation expectations. While the hawkish policy stance involves reacting strongly to any subsequent inflation, the pivot itself – if executed optimally – can lead to a soft landing since it aims to directly decrease inflation expectations and thereby inflation itself, reducing the need to actually depress employment.
The Central Bank’s Dilemma: Look Through Supply Shocks or Control Inflation Expectations?
Authors: Paul Beaudry, Thomas J. Thomas, Amartya Lahiri
From: Bank of Canada, University of British Columbia
How do agents perceive monetary policy strategies?
In this paper, Bauer et al. estimate perceived, forward-looking monetary policy rules each month using rich survey data from the Blue Chip Financial Forecasts spanning almost four decades of U.S. monetary policy. For each monthly survey from January 1985 to April 2023, they form a forecaster-by-horizon panel, which consists of forecasts for the federal funds rate, output gap, and inflation across 30–50 forecasters and horizons from zero to five quarters. The authors then estimate a simple forward-looking monetary policy rule that relates fed funds rate forecasts to macroeconomic forecasts in each month’s panel. In addition, they estimate a forward-looking inertial rule that includes lagged funds rate forecasts and thereby captures the perceived short-run response of monetary policy to economic conditions. Bauer et al. find:
First, the perceived responsiveness of monetary policy to the economy varies substantially over time, reflecting the Fed’s shifting concerns about economic data versus financial and other risks. It tends to be high during monetary tightening cycles when Fed policy is perceived to be data-dependent, and low during easing cycles and times of elevated economic and financial uncertainty. Second, following high-frequency monetary policy surprises on FOMC announcement dates, forecasters update their estimates of the monetary policy rule, indicating that they perceive monetary policy surprises to be informative about the rule followed by the Fed. The way forecasters update depends on the state of the economy, as the same surprise tightening indicates higher responsiveness to the economy in a strong economy and weaker responsiveness in a weak economy.
Perceptions about Monetary Policy
Authors: Michael D. Bauer, Carolin E. Pflueger, Adi Sunderam
From: Federal Reserve Bank of San Francisco, University of Chicago, Harvard University
