Learning central bank strategies at effective lower bound
A new BIS working paper examines how private sector agents learn new monetary policy strategies introduced at the effective lower bound (ELB) in an environment with large inflationary and deflationary shocks. The study finds that the period around liftoff from the ELB is crucial for learning, which can be delayed by recessionary shocks or halted by large inflationary shocks.
Navigating the ELB's learning curve
The past two decades have seen significant shifts in monetary policy, with the effective lower bound (ELB) on policy rates becoming a persistent feature in advanced economies.
This led central banks, including the Federal Reserve in 2020 and the ECB in 2021, to adopt new strategies like asymmetric average inflation targeting to counter the ELB's disinflationary bias.
A new BIS working paper explores how private sector agents learn these strategies when introduced at the ELB amidst large inflationary and deflationary shocks.
The research highlights that the period around the 'liftoff' of rates from the ELB is critical for agents to learn the new rules.
However, recessionary shocks can delay this learning, while large inflationary shocks may halt it entirely, preventing the new strategy from fully addressing the costs associated with the ELB.
The study also identifies that monetary policy shocks can significantly influence the learning process, adding another layer of complexity to strategy implementation.
Credibility and the inference challenge
Theoretical foundations for ELB-countering strategies often assume fully rational agents and complete central bank credibility, leading to immediate alignment of inflation expectations.
However, real-world implementation is complex; new strategies require learning and credibility.
This process is particularly challenging at the ELB, where the absence of co-movement between economic variables and interest rates hinders agents' statistical inference.
The paper models this learning process using Bayesian updating, where agents form priors and revise estimates over time.
Crucially, learning effectively halts during deep recessions at the ELB or at high inflation, where old and new policy rules converge.
This dynamic means that shocks, such as a return to recession or a sharp rise in inflation, can significantly impede the learning process before the new rule's benefits are fully realized.
Beyond the textbook ideal
This study offers a crucial reality check for central banks adopting new monetary policy frameworks.
It underscores that the theoretical benefits of strategies like average inflation targeting are heavily contingent on a complex learning process, which is highly vulnerable to economic shocks and imperfect credibility.
For policymakers, this implies that clear communication and consistent actions during critical periods, particularly around the 'liftoff' from the ELB, are paramount to effectively anchoring private sector expectations.