Research on monetary policy-making should adopt a more realistic approach, taking account of the fact that central banks have to make decisions in real time under great uncertainty about the state of the economy. That is the central message of a study by Stefano Neri and Tiziano Ropele, published in the June 2012 issue of the Economic Journal.
Their analysis, which is based on the real-time data available to policy-makers, indicates that the European Central Bank (ECB) is less aggressive towards inflation than in models based on perfect information. But the research also suggests that the ECB faces a more severe trade-off in the stabilisation of inflation and the output gap – the difference between real GDP and potential GDP.
Monetary policy is inevitably conducted under conditions of great uncertainty about the underlying state of the economy and without the benefit of hindsight. But until recently, this fundamental feature of actual policy-making has been largely overlooked in theoretical and empirical monetary analysis.
In most macroeconomic research, the study of monetary policy is conducted using ‘dynamic stochastic general equilibrium’ (DSGE) models, which make two peculiar assumptions.
The first assumption is that all ‘economic agents’, including the central bank, observe the state of the economy in a timely and accurate way and are thus able to identify the shocks that hit the economy. Second, the theoretical model is estimated using ex-post revised data.
But such a setting clashes with the considerable uncertainty under which monetary policy is implemented in reality. There are many sources of such uncertainty.
Several macroeconomic series, a prominent example being GDP, are published with lags with respect to the period to which they refer and are often subject to later, sometimes large, revisions. Other important economic variables, such as the output gap (the difference between real GDP and potential GDP), are not directly measurable and therefore must be estimated.
This new study can be viewed as a warning that empirical analyses should not neglect the inescapable features that characterise real-time monetary policy-making. The ability of a central bank to stabilise the economy and achieve the best combination of inflation and output gap volatility depends critically on the ability to measure the state of the economy accurately.
The study characterises the monetary policy of the ECB in an environment in which economic agents (firms and households) and the central bank have imperfect information on the state of the economy, which is estimated using real-time data for GDP and the output gap for the euro area. Real-time data are those available to policy-makers when they need to make decisions on official interest rates.
The analysis shows that in an uncertain environment, the ECB cannot achieve the best combination of inflation and output gap volatilities, as the efficient frontier (that is, the lowest achievable combinations of unconditional inflation and output gap volatilities) deteriorates suggesting a worsening of the trade-off faced by the ECB compared with the situation in which the state of the economy can be perfectly observed. Moreover, in an uncertain environment, the ECB adopts policy decisions that are more inertial.
‘Imperfect Information, Real-time Data and Monetary Policy in the Euro Area’ by Stefano Neri and Tiziano Ropele is published in the June 2012 issue of the Economic Journal.