Some Implications of Uncertainty and Misperception for Monetary Policy

40 Pages Posted: 29 Aug 2018 Last revised: 21 Feb 2019

See all articles by Christopher J. Erceg

Christopher J. Erceg

Board of Governors of the Federal Reserve System

James Hebden

Board of Governors of the Federal Reserve System

Michael T. Kiley

Board of Governors of the Federal Reserve System

David Lopez-Salido

Board of Governors of the Federal Reserve System

Robert J. Tetlow

Board of Governors of the Federal Reserve System

Date Written: 2018-08-23

Abstract

When choosing a strategy for monetary policy, policymakers must grapple with mismeasurement of labor market slack, and of the responsiveness of price inflation to that slack. Using stochastic simulations of a small-scale version of the Federal Reserve Board’s principal New Keynesian macroeconomic model, we evaluate representative rule-based policy strategies, paying particular attention to how those strategies interact with initial conditions in the U.S. as they are seen today and with the current outlook. To do this, we construct a current relevant baseline forecast, one that is loosely constructed based on a recent FOMC forecast, and conduct our experiments around that baseline. We find the initial conditions and forecast that policymakers face affects decisions in a material way. The standard advice from the literature, that in the presence of mismeasurement of resource slack policymakers should substantially reduce the weight attached to those measures in setting the policy rate, and substitute toward a more forceful response to inflation, is overstated. We find that a notable response to the unemployment gap is typically beneficial, even if that gap is mismeasured. Even when the dynamics of inflation are governed by a 1970s-style Phillips curve, meaningful response to resource utilization is likely to turn out to be worthwhile, particularly in environments where resource utilization is thought to be tight to begin with and inflation is close to its target level.

Keywords: Stochastic simulation, Mismeasurement, Monetary policy, Policy analysis, Uncertainty

JEL Classification: E31, E32, E52, C63

Suggested Citation

Erceg, Christopher J. and Hebden, James and Kiley, Michael T. and Lopez-Salido, David and Tetlow, Robert J., Some Implications of Uncertainty and Misperception for Monetary Policy (2018-08-23). FEDS Working Paper No. 2018-059. Available at SSRN: https://ssrn.com/abstract=3240414 or http://dx.doi.org/10.17016/FEDS.2018.059

Christopher J. Erceg (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th St. and Constitution Ave.
Washington, DC 20551
United States
202-452-2575 (Phone)
202-736-5638 (Fax)

James Hebden

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Michael T. Kiley

Board of Governors of the Federal Reserve System ( email )

20th and C Streets, NW
Washington, DC 20551
United States
202-452-2448 (Phone)
202-452-5296 (Fax)

David Lopez-Salido

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Robert J. Tetlow

Board of Governors of the Federal Reserve System ( email )

20th and C Streets, NW
Washington, DC 20551
United States

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