Fundamental uncertainty about the natural rate of interest: Info-gap as guide for monetary policy

In this paper we assume that the natural rate of interest is fundamentally uncertain. Based on a small scale macroeconomic model, info-gap theory is used to rank different monetary policy strategies in terms of their robustness against this uncertainty. Applied to the euro area, we find that a strategy that is responsive to deviations from the policy targets is more robust against natural rate uncertainty than the historical response of the ECB as reflected in an estimated Taylor rule. An inert or passive monetary strategy is least robust. Our analysis presents a methodology that is applicable in a wide range of policy analyses under deep uncertainty.
 
Keywords: Monetary Policy, Monetary Strategy, Knightian uncertainty, info-gaps, satisficing.
JEL classifications: E42, E47, E52.

Working paper no. 650