Seminar in Macroeconomics - Stéphane Dupraz (Banque de France)

How can a central bank avoid losing control over inflation expectations? Under rational expectations, respecting the Taylor principle—increasing rates more than one for one with inflation—prevents self-fulfilling inflation and defines an active monetary policy. We reconsider the issue away from rational expectations, for a large class of boundedly rational expectations featuring both limited foresight and long-term learning. We show three results. (1) When restricting monetary policy to a Taylor rule, the Taylor principle does not prevent self-fulfilling inflation but hyperinflation spirals, unless for unrealistically high degrees of foresight. (2) Against hyperinflation spirals, active monetary policy can be characterized without restricting policy to a Taylor rule, as a sufficient increase of a weighted average of present and future expected policy rates. The weights on future policy rates first increase but then decrease with the horizon, implying that delaying hikes too much requires larger hikes later, with a larger drop in output. (3) Yet, being slow in hiking rates can be optimal provided a large cost on output stabilization, as it spreads the output cost over time.