Precautionary Learning, Endogenously Asymmetric Loss Functions and Inflationary Biases∗

We consider a canonical model of monetary policy in which the central bank learns about underlying fundamentals by estimating the parameters of a Phillips curve while disregarding the role of the public’s expectations. We show that the bank’s loss function is endogenously asymmetric with respect to these estimates such that overestimates may be more or less costly than underestimates, introducing a precautionary motive in estimation. This motive implies the use of a variance-adjusted least-squares estimator for learning about the inflationunemployment trade-off. Under such ‘precautionary learning’the central bank sets low inflation targets, and the economy settles near a Ramsey equilibrium. ∗We thank Jess Benhabib, John Duffy, John Leahy, Tom Sargent and seminar participants at New York University (Abu Dhabi), the Southern Economics Association Conference, Society for Nonlinear Dynamics and Econometrics Conference, the Federal Reserve Banks of Dallas and Richmond, and the Computational Economics and Finance Conference for insightful comments. We also thank Wouter den Haan and two referees for outstanding advice. The usual disclaimer applies. †Address: New York University (Abu Dhabi), PO Box 903, New York, NY, 10276, USA. E-mail: [email protected]. ‡Address: Utah State University, Jon M. Huntsman School of Business, 3565 Old Main Hill, Logan, UT., 84322. E-mail: [email protected].