Risk Shocks and Monetary Policy in the New Normal

Risk shocks give rise to a tradeoff for monetary policy between inflation and output stabilization in the canonical New Keynesian model if they are large relative to the distance between the nominal interest rate and its lower bound. The tradeoff-inducing effects operate through expectational responses to the interaction between the perceived volatility of conventional level shocks and the available monetary policy space. At the same time, a given monetary policy stance becomes less effective. Optimal time-consistent monetary policy therefore calls for potentially sharp cuts in interest rates when risk is perceived to be elevated, even if this risk does not materialize in any actual disturbances to the economy. The new normal for monetary policy may be one in which policymakers should both constantly lean against a tendency for inflation expectations to anchor below target-operating the economy above potential in the absence of disturbances-whilst accepting that inflation will settle potentially materially below target, and respond nimbly to changes in public perceptions of economic risk.