Working Paper: NBER ID: w21569
Authors: Jeremy C. Stein; Adi Sunderam
Abstract: We develop a model of monetary policy with two key features: (i) the central bank has private information about its long-run target for the policy rate; and (ii) the central bank is averse to bond-market volatility. In this setting, discretionary monetary policy is gradualist, or inertial, in the sense that the central bank only adjusts the policy rate slowly in response to changes in its privately-observed target. Such gradualism reflects an attempt to not spook the bond market. However, this effort ends up being thwarted in equilibrium, as long-term rates rationally react more to a given move in short rates when the central bank moves more gradually. The same desire to mitigate bond-market volatility can lead the central bank to lower short rates sharply when publicly-observed term premiums rise. In both cases, there is a time-consistency problem, and society would be better off appointing a central banker who cares less about the bond market. We also discuss the implications of our model for forward guidance once the economy is away from the zero lower bound.
Keywords: monetary policy; time-consistency; bond market volatility; forward guidance
JEL Codes: E44; E52; E58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| central bank's private information about long-run target (E52) | central bank's gradualism in monetary policy (E52) |
| central bank's gradualism in monetary policy (E52) | time-consistency problem (D15) |
| central bank's gradualism in monetary policy (E52) | long-term rates reacting strongly to short-term rate changes (E43) |
| long-term rates reacting strongly to short-term rate changes (E43) | feedback loop distancing policy rate from target (E61) |
| central bank's private information (E58) | central bank's aversion to bond market volatility (E58) |
| central bank's aversion to bond market volatility (E58) | inefficiency in monetary policy adjustments (E49) |
| appointment of a central banker less concerned about bond market volatility (E58) | resolution of inefficiency (D61) |
| forward guidance (E60) | mitigation of time-consistency problem (D15) |
| central bank's future private information not forecastable (E58) | harm when forward guidance implemented away from zero lower bound (E52) |
| central bank's inability to commit to not smoothing private information (E58) | inefficiency from an ex ante perspective (D61) |