Should Uncertain Monetary Policy-Makers Do Less?

Abstract

This paper examines the empirical importance of parameter uncertainty for monetary policy-making in the United Kingdom, using a method pioneered by Brian Sack of the U.S. Federal Reserve. Using a VAR model of the U.K. economy and an assumed quadratic loss function for the policy-maker, an optimal interest rate rule is calculated first ignoring parameter uncertainty, then assuming that the parameter uncertainty is given by the estimated standard errors on the VAR coefficients. These rules are compared with the estimated interest rate equation from the VAR. The optimal rule accounting for parameter uncertainty results in a less aggressive path for official interest rates than when parameter uncertainty is ignored. However, the estimates of parameter uncertainty are not so large that the optimal rule matches all the characteristics of the actual path of official rates.

JEL Classification: E52, E58