Optimal monetary policy with uncertain private sector foresight
What this paper finds — and why it matters
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.
Summary of a forthcoming paper, AI-assisted and human-reviewed. See the linked original for the authoritative claims and full conditions.
Q1. What is the NK-FHP model and how does it differ from standard New Keynesian models?
In the NK-FHP model, households and firms are boundedly rational because they evaluate state-contingent paths only up to a finite horizon; beyond that horizon they extrapolate longer-run beliefs by averaging over past data, making those beliefs adaptive rather than anchored at the target. When agents have long planning horizons, the model approximates rational expectations: inflation expectations are well anchored, disinflations are relatively costless, and policy transmits quickly. When planning horizons are short, longer-run inflation expectations can become unanchored, disinflations are costly, and policy transmission lags lengthen. The NK-FHP model thus nests both extremes and provides micro-foundations for the “inflation scares” discussed by Goodfriend (1993).
Q2. What is the “inflation scares problem” and why does it matter for optimal policy?
An inflation scare occurs when agents’ longer-run inflation expectations deviate persistently from the central bank’s target because agents with short planning horizons update beliefs adaptively, and past high inflation feeds forward into current expectations. This creates a welfare-relevant asymmetry: once expectations become unanchored, a disinflation is costly in output because the central bank must build credibility against backward-looking expectations. The standard NK model with rational expectations does not generate this problem—rational agents’ inflation expectations are pinned to the target irrespective of history—so it cannot address the design of policy specifically to prevent scares from materializing.
Q3. What is the “preemptive motive” and how does it modify the leaning-against-the-wind principle?
Optimal time-consistent policy under uncertain private-sector foresight adds a preemptive motive to the standard leaning-against-the-wind (LATW) principle: the central bank contracts demand not just in response to current output-gap and inflation deviations, but also to prevent expectations from becoming unanchored. Under the standard NK LATW result (Clarida, Galí, and Gertler 1999), the policymaker responds to the means of output and inflation. Under uncertain and potentially short-horizon foresight, optimal policy also depends on the distribution of output and inflation, as well as agents’ beliefs about future inflation—specifically, whether those beliefs risk drifting away from target. The preemptive motive implies a more aggressive policy response to the risk of an inflation scare even before the scare has fully materialized.
Q4. How does the paper relate to the post-pandemic inflation experience?
Using parameter estimates from an estimated version of the NK-FHP model, the paper applies the optimal policy framework to quantify how much the preemptive motive matters during the recent post-pandemic inflation surge. The model—which has been shown in related work (Gust, Herbst, and López-Salido 2022, 2024) to fit macroeconomic time series substantially better than hybrid NK models and to account for initial underreaction and subsequent overreaction of inflation forecasts—is well suited to analyze an episode where longer-run inflation expectations initially remained anchored but later showed signs of drift. The paper’s quantification indicates that risk-management considerations, including the preemptive motive, significantly affect the optimal policy path.
Key concepts
finite-horizon planning (NK-FHP) : a bounded-rationality framework (Woodford 2018) in which agents evaluate only those state-contingent paths within a finite planning horizon, updating beliefs about events beyond the horizon adaptively from past data.
inflation scares : episodes (Goodfriend 1993) in which agents’ longer-run inflation expectations deviate persistently from the central bank’s target, making disinflation costly; the NK-FHP model provides micro-foundations for such scares.
preemptive motive : the additional incentive for a policymaker to tighten beyond what current output-gap and inflation deviations alone would prescribe, specifically to prevent longer-run inflation expectations from becoming unanchored.
time-consistent policy under uncertainty : optimal policy that does not rely on commitment and hence accounts for future re-optimization; in this model it must also account for the non-additive uncertainty arising from a distribution of planning horizons.