Be Wary of Simple Policy Rules
As the economy has strengthened over the past few years but core inflation remains stuck well below 2 percent, research has sought to shed light on why inflation has not necessarily moved in the direction or to the magnitude predicted by traditional models centered on resource slack. Similarly, inflation was remarkably stable during the past downturn, declining less than many models would have predicted, which was largely pinned on well-anchored inflation expectations.Simon Gilchrist and Egon Zakrajšek offer evidence that it is not solely resource slack and inflation expectations that influence inflation.2 Financial conditions also play a role as financially stressed firms and industries more reliant on external financing are less apt to reduce prices in downturns in order to preserve cash flow. The result is more modest disinflationary pressure than would be expected based on demand and slack conditions alone. To that end, monetary policy should be wary of using a specific interest-rates rule when financial conditions may be affecting firms’ pricing behavior. Following financial shocks, policymakers should focus more heavily on stabilizing output as “rules that put a great deal of weight on inflation stabilization lead to significantly worse economic outcomes.”
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