Learning monetary policy strategies at the effective lower bound with sudden surprises
Summary
Focus
With the onset of the Great Recession and the ensuing slow economic recovery, the effective lower bound (ELB) on policy rates went from being an isolated curiosity to a prominent feature of the monetary policy environment. In response, central banks adopted new strategies to offset the risks the ELB poses. Notably, ELB risks were a motivating factor for different framework reviews. Some major central banks implemented these changes while policy rates were still at the ELB during the Covid-19 pandemic. These economies recovered quite swiftly following the pandemic, but a mix of large shocks subsequently caused inflation to reach levels unseen in the past 40 years.
Contribution
We investigate how private sector agents might learn new monetary strategies introduced at the ELB in an environment in which large inflationary and deflationary shocks may occur unexpectedly. The rule we consider is a form of asymmetric average inflation targeting. We examine these issues in the context of a standard New Keynesian framework in which the economy is driven to the ELB by large negative demand shocks. The central bank then announces that it is adopting a new policy rule to counter the ELB. But we also assume the central bank does not announce all of the elements of the new policy function or cannot do so with full credibility. Instead, agents must learn them. We also consider how the learning process evolves when the economy experiences either another round of recessionary shocks that drive it back to the ELB or shocks that generate a bout of inflation.
Findings
The most crucial time for learning runs from when rates would be near lift-off under the old strategy through early lift-off under the new rule. Recessionary shocks during this period could delay learning while large inflationary shocks could halt it entirely, inhibiting the new strategy's ability to address the costs associated with the ELB. As an example, we examine how our model interprets the post-Covid experience in the United States, when inflation surged soon after the Federal Reserve adopted flexible average inflation targeting. We find that matching the data requires large monetary policy shocks that hold rates much lower than the new policy rule would prescribe based on output and inflation alone. In addition, monetary policy shocks can have important feedback on the learning process.
Abstract
We examine how private sector agents might learn a new monetary strategy introduced while policy rates are at their effective lower bound (ELB) in an environment with large inflationary and deflationary shocks. We consider the adoption of a new asymmetric average inflation targeting rule aimed at countering the disinflationary bias imparted by the ELB. The most crucial time for learning runs from when rates would be near liftoff under the old strategy through early liftoff under the new rule. Recessionary shocks during this time could delay learning while large inflationary shocks could outright stop it, inhibiting the ability of the new strategy to address the costs associated with the ELB. Using the US post-Covid experience as an example, we also find that the monetary policy shocks can have important feedback on the learning process.
JEL classification: E52, C63, E31
Keywords: new framework, central bank's communications, deflationary bias, inflation surprises, asymmetric average inflation targeting, imperfect credibility, liftoff, Bayesian learning
