Uncertainty about the length of the monetary policy transmission lag: implications for monetary policy

This paper examines implications for monetary policy of uncertainty about the length of the monetary policy transmission lag in a stochastic environment. Two key questions are asked. Firstly, which type of inflation-forecast-based rules work well when the central bank does not know the length of the monetary policy transmission lag? The results show that rules that are less aggressive and more forward looking are more robust. That is, the performance of these rules are least affected by lag uncertainty. However, it is still the case that relatively more aggressive and less forward looking rules will produce lower inflation variability. With any inflation forecasting model, policymakers must take a view on how quickly their actions impact on inflation. There will always be a significant degree of uncertainty surrounding this transmission lag such that a central bank is unlikely to get this right all the time. The second question asks, is it better to overestimate or underestimate this transmission lag? When the lag is overestimated (underestimated), the central bank behaves as if inflation is harder (easier) to control than it really is. The results show that a strategy of overestimating is superior to underestimating the lag. In fact, it may be even be a preferred strategy to knowing the true lag.