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Optimal normalization policy under behavioral expectations

Working paper 800
Working Papers

Gepubliceerd: 05 februari 2024

Door: Alexandre Carrier Kostas Mavromatis

We examine optimal normalization strategies for a central bank confronted with persistent inflationary shocks and a potential de-anchoring of expectations. Our analysis characterizes optimal monetary policy, when the central bank uses both the short-term interest rate and the balance sheet, in a framework in which agents’ expectations can deviate from the rational expectations benchmark. Optimal policy is developed using a sufficient statistics approach, highlighting the dynamic causal effects of changes in each policy instrument on the central bank’s targets. Three key insights emerge: first, the interest rate is identified as the key instrument for managing inflationary pressures, outperforming balance sheet adjustments. Second, having anchored expectations about the path of quantitative tightening (QT) is crucial to mitigate economic downturns and controlling inflation, within the framework of an optimal balance sheet strategy set under a predefined interest rate rule. Lastly, when both the interest rate and QT are set optimally, expectations are found to significantly influence the optimal interest rate trajectory, whereas their impact on the optimal QT path is comparatively minimal.

Keywords: Optimal monetary policy; de-anchored expectations; normalization strategy
JEL codes E52; E71; D84

Working paper no. 800

800 - Optimal normalization policy under behavioral expectations

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Research highlights

  • We examine optimal normalization strategies for a central bank confronted with persistent inflationary shocks and a potential de-anchoring of expectations. Using a sufficient statistics approach, we characterize optimal policy when both the policy rate and the balance sheet are deployed.
  • We show, first, that when set optimally, the policy rate is the key instrument for managing inflationary pressures, outperforming balance sheet adjustments.
  • Second, we find that anchored expectations about the path of quantitative tightening (QT) are crucial to mitigate economic downturns and controlling inflation, within the framework of an optimal balance sheet strategy set under a predefined interest rate rule.
  • Finally, we show that when both the interest rate and QT are set optimally, expectations are found to significantly influence the interest rate policy, whereas their impact on the optimal QT path is comparatively minimal.

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