Policy uncertainty can magnify cost shocks – BoI paper

A working paper published by the Bank of Italy studies the interaction of cost‐push shocks with monetary policy.

In Disinflationary shocks and inflation target uncertainty, Stefano Neri and Tiziano Ropele note that in New Keynesian models, favourable cost-push shocks lower inflation and increase output. But if a central bank does not target inflation perfectly, such shocks can become contractionary.

The authors present a small-scale New Keynesian model of the economy. Their model includes a central bank that has an inflation target but follows it in an imperfect way.

They find that any negative effects of favourable cost-push shocks on output are increased when monetary policy is at the effective lower bound. But the central bank can reduce this negative effect if it reduces uncertainty around how it follows its inflation target, the authors say.

The authors sketch possible lines of enquiry for future research on the same lines. Further work in the field could examine data on economies where central banks have different degrees of transparency around their inflation targets. Research could look at how these countries were affected by common cost-push shocks, such as changes in oil prices.