Inflation Risk and Optimal Monetary Policy

This paper shows that the optimal monetary policies recommended by New Keynesian models still imply a large amount of inflation risk. We calculate the term structure of inflation uncertainty in New Keynesian models when the monetary authority adopts the optimal policy. When the monetary policy rules are modified to include some weight on a price path, the economy achieves equilibria with substantially lower long-run inflation risk. With either sticky prices or sticky wages, a price path target reduces the variance of inflation by an order of magnitude more than it increases the variability of the output gap. The views expressed in this paper are those of the authors and do not necessarily reflect official positions of the Federal Reserve Bank of St. Louis, the Federal Reserve System, or the Board of Governors.