Working Paper

Optimal Monetary Policy with Uncertain Private Sector Foresight

Abstract: Central banks operate in a world in which there is substantial uncertainty regarding the transmission of its actions to the economy because of uncertainty regarding the formation of private-sector expectations. We model private sector expectations using a finite horizon planning framework: Households and firms have limited foresight when deciding spending, saving, and pricing decisions. In this setting, contrary to standard New Keynesian (NK) models, we show that "an inflation scares problem" for the central bank can arise where agents' longer-run inflation expectations deviate persistently from a central bank's inflation target. We formally characterize optimal time-consistent monetary policy when there is uncertainty about the planning horizons of private sector agents and a risk of inflation scares. We show how risk management considerations modify the optimal leaning-against-the-wind principle in the NK literature with a novel, additional preemptive motive to avert inflation scares. We quantify the importance of such risk management considerations during the recent post-pandemic inflation surge.

Keywords: Finite horizon planning; Optimal time-consistent policy under uncertainty; Leaning against the wind; Attenuation principle;

JEL Classification: C11; E52; E70;

https://doi.org/10.17016/FEDS.2024.059

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2024-08-02

Number: 2024-059