Monetary policy must respond aggressively to persistent shocks – BoI paper

Central banks need to use monetary policy more aggressively when confronted with macroeconomic shocks with persistent effects, a working paper published by the Bank of Italy finds.

In Benefits of gradualism or costs of inaction? Monetary policy in times of uncertainty, Giuseppe Ferrero, Mario Pietrunti and Andrea Tiseno use a simple forward-looking New Keynesian macroeconomic model. Their model relaxes the assumption that central banks have complete information about the economy, instead allowing for uncertainty and assuming that parties have asymmetric information.

Private sector firms observe developments in economic indicators as they occur, the authors write, but “the central bank observes them with a one-period delay”. This presents the central bank with a Bayesian decision problem of minimising expected future welfare losses in an uncertain environment.

The authors then test how changes in monetary policy interact with other macroeconomic shocks. When there is high uncertainty but macroeconomic shocks do not last long, central banks can afford to exercise caution in their monetary policy, the authors say.

But this changes when “shocks are persistent enough to move agents’ expectations away from the central bank’s target for a protracted period of time”. Then central banks need to respond more aggressively, accepting a higher level of present macroeconomic volatility in order to prevent large deviations from its targets in the future.