Monetary Policy Response to Oil Price Shocks

How should monetary authorities react to an oil price shock? The New Keynesian literature has concluded that ensuring complete price stability is the optimal thing to do. In contrast, this paper argues that a meaningful trade-off between stabilizing inflation and the welfare relevant output gap arises in a distorted economy once one recognizes (i) that oil (energy) cannot be easily substituted by other factors in the short-run, (ii) that there is no fiscal transfer available to policymakers to neutralize the steady-state distortion due to monopolistic competition, and (iii) that increases in oil prices also directly affect consumption by raising the price of fuel, heating oil, and other energy sources. While the first two conditions are necessary to introduce a microfounded monetary policy trade-off, the third one makes it quantitatively significant. The optimal precommitment monetary policy relies on unobservables and is therefore hard to implement. To address this concern, I derive a simple interest rate feedback rule that mimics the optimal plan in all relevant dimensions but that depends only on observables, namely core inflation, oil price inflation, and the growth rate of output.