Avoiding Dark Corners: A Robust Monetary Policy Framework - IMF

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WP/15/134

Avoiding Dark Corners:

A Robust Monetary Policy Framework for the United States

by Ali Alichi, Kevin Clinton, Charles Freedman, Ondra Kamenik, Michel Juillard, Douglas Laxton, Jarkko Turunen, and Hou Wang

IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

© 2015 International Monetary Fund

WP/15/134

IMF Working Paper Research Department Avoiding Dark Corners: A Robust Monetary Policy Framework for the United States Prepared by Ali Alichi, Kevin Clinton, Charles Freedman, Ondra Kamenik, Michel Juillard, Douglas Laxton, Jarkko Turunen, and Hou Wang Authorized for distribution by Nigel Chalk June 2015 IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. Abstract The Fed has taken several steps towards strengthening its monetary framework over the past several years. Those steps have supported the Fed’s efforts to stimulate the economy through forward guidance despite being constrained by having policy rates at zero. We show that an optimal control approach to monetary policy, which includes the publication of a baseline forecast and a description of the uncertainties around that outlook, combined with an improvement in the Fed’s communications toolkit, could further enhance the effectiveness of Fed policy. In the current conjuncture, such a risk management approach to monetary policy would result in both a later liftoff of policy rates and a modest, but planned, overshooting of inflation. JEL Classification Numbers: E30, E31, E58 Keywords: Inflation Targeting, Monetary Policy, Optimal Control Author’s E-Mail Address: [email protected]; [email protected]; [email protected]; [email protected]; [email protected]; [email protected]; [email protected]; [email protected]

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Table of Contents I. INTRODUCTION AND BACKGROUND ......................................................................................4 II. RECENT DEVELOPMENTS AT THE FED .................................................................................7 III. LOSS MINIMIZING MONETARY POLICY BASED ON A SIMPLE MODEL ...........................12 III.1 Background ..............................................................................................12 III.2 Outline of the model ................................................................................13 III.3 Illustrative simulation results ...................................................................15 III.4 Sensitivity analysis: variants of the model...............................................17 III.5 Forecast confidence bands and alternative simulations ...........................23 III.6 A summing up ..........................................................................................27 IV. PUBLICATION OF ENDOGENOUS INTEREST RATE FORECASTS..........................................28 V. WHOSE FORECAST SHOULD BE PUBLISHED? .....................................................................30 VI. CONCLUSION .....................................................................................................................32 Appendix 1. Definitions ...................................................................................38 Appendix 2. The model....................................................................................40 Appendix 3: Minimizing the loss function ......................................................45

4 I. INTRODUCTION AND BACKGROUND This paper has a number of objectives.1 One objective is to illustrate the value of an optima