Sources of Uncertainty in Monetary Policy

I’ve been talking about monetary policy and uncertainty lately (e.g., here and here, and a different type here), but I realized I hadn’t taken the time to categorize the types of uncertainty that exist.  Fortunately, Otmar Issing has done it for me in this European Central Bank publication:

Monetary policy in uncharted territory, Professor Otmar Issing, Stone Lecture, November 2003:  2. The forms of uncertainty How does monetary theory suggest central banks should deal with uncertainty? The answer is dependent on the particular form of uncertainty... First, there is uncertainty on prevailing economic conditions ... like the output gap, equilibrium real interest rates, or various measures of excess liquidity - and … [about] the shocks driving observed economic developments. By and large, the recent literature seems to consider this source of uncertainty as easy to deal with ... [Second] monetary theorists speak of model uncertainty. This … can take the form of ... imperfect knowledge of the parameters which characterise ... any particular model. Brainard's ... conservatism principle is probably the most widely quoted result on how to deal with parameter uncertainty. A large body of recent evidence, however, has pointed out that conservatism is not a robust outcome. An aggressive, rather than cautious, response to inflationary shocks ... is advisable when there is uncertainty on the exogenous degree of inflation persistence.

...But this is not the end of uncertainty. A third class of uncertainty is that due to ... reaction of economic agents and financial markets to its own policy decisions and announcements. Conversely, economic agents may be unsure about the precise motivations and actions of central banks and other economic agents. In the realm of monetary policy, the level of uncertainty .. is … inversely related to central bank credibility. Luckily, in this field we do have some robust policy results. … A firm response to inflationary shocks is also necessary, especially if agents take into account the possibility that the anti-inflationary determination of the central bank may wane over time. Finally, the announcement of a monetary policy strategy also contributes to dispel uncertainty on the actions of the central bank.

This notes that there are situations where an aggressive response to inflation is optimal, e.g. when inflationary expectations begin to drift upward as actual inflation is allowed to rise over time. Currently, the market's expectation that the Fed may pause can be interpreted as markets believing the Fed will pay more attention to the potential for falling output than to rising prices in coming months. The Fed may want to correct this perception to avoid higher inflationary expectations (though this report implies that not all Fed officials believe a pause translates into higher inflationary expectations so long as the reasons for the pause are properly communicated).  For example, here are recent comments from Chicago Fed president Michael Moskow:

Putting it all together, ... If we indeed start to see a string of higher inflation numbers, people may begin to expect permanently higher inflation. Such expectations could become self-fulfilling if they become built into the behavior of households and businesses. And this would have adverse effects on longer term economic performance. If this occurred, the Fed would need to respond accordingly in order to restore price stability.

This implies that any sign of an upward drift in inflationary expectations will bring about a policy response to re-anchor expectations at the target level.