a1 Justus Liebig University Giessen
Empirical evidence suggests that the instrument rule describing the interest rate–setting behavior of the Federal Reserve is nonlinear. This paper shows that optimal monetary policy under parameter uncertainty can motivate this pattern. If the central bank is uncertain about the slope of the Phillips curve and follows a min–max strategy to formulate policy, the interest rate reacts more strongly to inflation when inflation is further away from target. The reason is that the worst case the central bank takes into account is endogenous and depends on the inflation rate and the output gap. As inflation increases, the worst-case perception of the Phillips curve slope becomes larger, thus requiring a stronger interest rate adjustment. Empirical evidence supports this form of nonlinearity for post-1982 U.S. data.
(Online publication February 10 2010)
I am grateful to Petra Gerlach-Kristen, Efrem Castelnuovo, an associate editor of this journal, and two anonymous referees for very insightful comments and suggestions and to Daniel Leigh for providing his series of estimated inflation targets. I thank seminar participants at the annual meetings of the Verein für Socialpolitik (Graz 2008), the EEA (Milan 2008), the Quantitative Macroeconomics Meeting in Aachen, FU Berlin, and the University Duisburg-Essen for fruitful discussions.