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This paper examines the implications of uncertainty about the effects of monetary policy for optimal monetary policy with an application to the current situation. Using a stylized macroeconomic model, I derive optimal policies under uncertainty for both conventional and unconventional monetary policies. According to an estimated version of this model, the US economy is currently suffering from a large and persistent adverse demand shock. Optimal monetary policy absent uncertainty would quickly restore real GDP close to its potential level and allow the inflation rate to rise temporarily above the longer-run target. By contrast, the optimal policy under uncertainty is more muted in its response. As a result, output and inflation return to target levels only gradually. This analysis highlights three important insights for monetary policy under uncertainty. First, even in the presence of considerable uncertainty about the effects of monetary policy, the optimal policy nevertheless responds strongly to shocks: uncertainty does not imply inaction. Second, one cannot simply look at point forecasts and judge whether policy is optimal. Indeed, once one recognizes uncertainty, some moderation in monetary policy may well be optimal. Third, in the context of multiple policy instruments, the optimal strategy is to rely on the instrument associated with the least uncertainty and use alternative, more uncertain instruments only when the least uncertain instrument is employed to its fullest extent possible.

The Federal Reserve has been criticized by some for not acting aggressively enough to meet its statutory mandate of maximum employment and price stability (see, for example, Krugman, 2012). Inflation is below the Federal Reserve’s preferred 2% rate and the unemployment rate is elevated and, according to many forecasts, these conditions are expected to persist for some time. These commentators argue that a more expansionary monetary policy stance would lower the path of the unemployment rate and raise the inflation rate. According to this argument, under reasonable assumptions regarding preferences over the two objectives, such a policy would bring the Fed closer to its mandated objectives more quickly. The claim that the Fed is responding insufficiently to the shocks hitting the economy rests on the assumption that policy is made with complete certainty about the effects of policy on the economy. Nothing could be further from the truth. Policymakers are unsure of the future course of the economy and uncertain about the effects of their policy actions. Uncertainty about the effects of policies is especially acute in the case of unconventional policy instruments such as using the Fed’s balance sheet to influence financial and economic conditions. And, as is well known since the seminal work of Brainard (1967), uncertainty about the effects of policy may be an argument for attenuated policy responses to shocks. This conservatism principle of optimal policy under uncertainty implies that one cannot necessarily infer from point forecasts of persistently low inflation and elevated unemployment that monetary policy is suboptimal. This paper examines the implications of uncertainty for optimal monetary policy with an application to the current situation. I start with a stylized static macroeconomic model and derive optimal monetary policies under both certainty and uncertainty. I then examine optimal policy in the current environment using an estimated version of the stylized model. In this model, the Federal Reserve possesses two monetary policy instruments: the federal funds rate and unconventional balance sheet policies. The federal funds rate is assumed to be subject to a zero lower bound, giving rise to the use of the balance sheet instrument. Based on empirical studies, uncertainty regarding the effects of unconventional balance sheet policies on the economy is greater than for conventional policies. According to the estimated stylized model, the US economy is currently suffering from a large and persistent adverse demand shock. Optimal monetary policy absent uncertainty would quickly restore real GDP close to its potential level and allow the inflation rate to temporarily rise somewhat above the 2% longer-run target. Thus, this model captures the argument of critics that more aggressive policy could bring the economy rapidly close to target levels in a world of perfect certainty. In contrast, the optimal policy under uncertainty is much more muted in its response to the negative demand shock. As a result, output and inflation return to their target levels only gradually. This analysis highlights three important insights for monetary policy under uncertainty. First, even in the presence of considerable uncertainty about the effects of monetary policy, the optimal policy nevertheless responds strongly to shocks: uncertainty does not imply inaction. Indeed, in the estimated model, the optimal conventional and unconventional policy responses in the current situation are quite strong, just not as strong as would be called for absent uncertainty. Second, one cannot simply look at point forecasts and judge whether policy is optimal or not. One needs to evaluate policy in the context of the distribution of forecasts that accounts for uncertainty. Indeed, once one recognizes uncertainty, some moderation in monetary policy may well be optimal. Third, in the context of multiple policy instruments, the optimal strategy is to rely on the instrument with the least uncertainty and use other, more uncertain instruments, only when the least uncertain instrument is employed to its fullest extent possible. The paper is organized as follows. Section 2 describes a simple static model and derives optimal monetary policy under certainty and uncertainty. Section 3 extends the model to include an unconventional monetary policy instrument and the zero lower bound on nominal interest rates. Section 4 reports optimal monetary policy based on empirical estimates of uncertainty regarding the effects of monetary policy actions. Section 5 applies these results to the current situation and reports forecasts under alternative monetary policy assumptions. Section 6 examines the effects of costs to unconventional monetary policy not captured by the model. Section 7 concludes.

7. Conclusion The analysis presented here shows how optimal monetary policy that accounts for parameter uncertainty may appear to be suboptimal when uncertainty is ignored. The paper’s basic approach to parameter uncertainty is not novel and is found in the theoretical analysis of Brainard (1967), the empirical studies of Federal Reserve monetary policy by Rudebusch, 2001, Sack, 2000, Goodhart, 1998 and Blinder, 1998 accounts of monetary policy in practice. In the current circumstances, where the Federal Reserve and other central banks rely on unconventional balance sheet policy tools, uncertainty regarding the effects of policy actions is particularly relevant. Although there is compelling evidence that the Fed’s balance sheet policies have reduced long-term interest rates, considerable uncertainty remains regarding their effects on broader financial conditions, economic activity, and inflation. It is difficult to quantify the uncertainty regarding the macroeconomic effects of balance sheet policies. However, evidence suggests that the uncertainty regarding their effects is considerably larger than that of conventional monetary policy.******* This analysis is subject to a number of caveats that point to directions for further research. First, as discussed in Craine, 1979 and Bernanke, 2004, the effects of uncertainty on monetary policy depend on the model and the sources of uncertainty. The model used here is highly stylized and abstracts from expectations channels. A more thorough analysis using a richer dynamic macroeconomic model is needed to better quantify the effects of uncertainty. Such an analysis should also consider a broader set of sources of uncertainty, including model misspecification (see, for example, Orphanides and Williams, 2006 and references therein). Second, the analysis presented here ignores the ability of the policymaker to learn over time. In an environment where the policymaker can learn, there is an incentive to experiment, which works in opposition to the attenuation motive analyzed here (see Sack, 1998 and Wieland, 2000, and references therein). Third, the analysis takes the policymaker objective function as exogenously given. Levin and Williams (2003) show that the attenuation effects of parameter uncertainty are reduced in some cases when the central bank’s loss is explicitly defined to be the welfare of the representative agent (see also Levin et al., 2006 and Edge et al., 2010). Finally, the analysis is based on a Bayesian approach and it would be useful to compare the results to the alternative approach of robust control, as in Tetlow and von zur Muehlen, 2001 and Giannoni, 2002. Finally, this paper has focused exclusively on conventional and balance sheet policies. Some central banks, including the Federal Reserve, have also turned to the use of forward guidance to influence expectations of the future path of short-term interest rates. Analysis of the optimal use of forward guidance, including uncertainty associated with such policies, is beyond the scope of this paper and is left for future research (see Rudebusch and Williams, 2008 and Woodford, 2013, for discussions of the potential usefulness and challenges associated with forward guidance).