Optimal monetary policy with uncertain private sector foresight

Central banks must set policy under uncertainty about how private-sector expectations form, which changes how monetary policy transmits to output and inflation. This paper studies optimal time-consistent monetary policy using a New Keynesian finite-horizon planning (NK-FHP) model in which households and firms have limited foresight: they solve structural problems only up to a finite horizon, and update their beliefs about longer-run inflation by averaging over past data. In this setting—unlike in standard New Keynesian models—an “inflation scares” problem can arise: agents’ longer-run inflation expectations can deviate persistently from the central bank’s target, generating costly and prolonged disinflations. The authors formally characterize optimal policy when the planning horizons of private-sector agents are uncertain and a risk of inflation scares is present, showing that risk-management considerations modify the standard “leaning against the wind” principle with a novel preemptive motive: the optimal policy responds more aggressively to the risk of unanchoring to prevent inflation scares from materializing. An estimated version of the model is used to quantify how much this preemptive motive mattered during the post-pandemic inflation surge.

The Federal Reserve's Large-Scale Asset Purchase Programmes: Rationale and Effects

This 2012 Economic Journal paper by D’Amico, English, López-Salido, and Nelson estimates how the Federal Reserve’s large-scale asset purchase (LSAP) programmes of 2008-2011 lowered longer-term US Treasury yields, disaggregating the total effect into three transmission channels within a single unified empirical framework that nests all of them: an expectations/signalling channel (LSAPs convey information about the future path of short-term policy rates, operating purely through the expectations hypothesis of the term structure, with no imperfect asset substitution required); a scarcity (preferred-habitat) channel (a Fed purchase withdraws a specific maturity from private holders, creating excess demand that depresses yields at that maturity and nearby ones because investors do not substitute perfectly across maturities); and a duration channel (Fed purchases remove aggregate duration risk from the market, lowering term premiums more broadly across the maturity spectrum). Using weekly CUSIP-level (individual-security) US Treasury data from December 2002 to October 2008 — a pre-LSAP estimation window chosen specifically to avoid endogeneity that contaminates the LSAP period itself, since the Fed tended to buy securities precisely when yields were rising — the authors regress yields and term-premium components on the fraction of privately held nominal Treasuries in a given maturity bucket (PHNT) and an aggregate duration-risk gap measure (DG), finding both coefficients positive and statistically significant across maturities from 7 to 30 years (adjusted R-squared of 0.46-0.70), a result that survives controlling for Treasury option-implied volatility, a flight-to-quality proxy, and a business-conditions index. Applying these pre-crisis coefficients to the actual scale and maturity concentration of the LSAP programmes, the authors estimate the first LSAP ($300 billion, concentrated in the 2-10 year sector) lowered longer-term Treasury yields by roughly 35 basis points (about 23bp from the scarcity channel plus 12bp from the duration channel), and the second LSAP ($600 billion) by roughly 45 basis points (about 35bp scarcity plus 10bp duration) — equivalent, using a standard rule-of-thumb conversion, to federal-funds-rate cuts of about 140 and 180 basis points respectively. A supporting intraday event study of the August 10, 2010 FOMC/FRBNY reinvestment announcement, together with the finding that scarcity and duration coefficients remain significant when controlling for proxies of expected short-rate paths, leads the authors to state that their results suggest LSAPs do not operate solely or even primarily via the expectations channel, and that preferred-habitat elements are a necessary ingredient for understanding monetary transmission to long-term rates even away from the zero lower bound (their pre-LSAP sample predates the ZLB period). The scope of the quantitative results is explicitly limited to nominal Treasury securities — the paper does not directly quantify the effects of the agency debt and MBS purchased in the first LSAP round — and rests on extrapolating relationships estimated in a short, pre-crisis, non-LSAP sample to the LSAP period, a limitation the authors themselves flag.

David López-Salido | Macro Paper Warehouse

Optimal monetary policy with uncertain private sector foresight

The Federal Reserve's Large-Scale Asset Purchase Programmes: Rationale and Effects