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Monetary Policy, Employment Shortfalls, and the Natural Rate Hypothesis

Michael T. Kiley
Federal Reserve Board Working Paper No. 2024-032

Summary

This paper examines the effects of asymmetric loss functions—where the costs of employment shortfalls (output below potential) are greater than the costs of strong employment—on optimal monetary policy under the natural rate hypothesis. It argues that asymmetric policies may have unintended consequences:

1. Exacerbation of Activity Shortfalls: Asymmetric monetary policies lead to more frequent and severe economic downturns. This occurs because expectations adjust under the natural rate hypothesis to preserve long-run neutrality, forcing policies to over-accommodate positive supply shocks, which in turn deepens contractions.

2. Inflationary Bias: The paper demonstrates that asymmetric policies result in upward inflation bias. Even in cases where aggregate demand shocks dominate, policies tilt toward inflation to support stronger economic activity, leading to higher inflation rates.

3. Preference for Symmetry: The study concludes that central banks should operate with greater symmetric loss functions (equal costs for outcomes above and below potential) to improve welfare. Greater symmetry reduces both activity shortfalls and inflation bias, suggesting that any disregard for economic strength may stem from factors beyond loss function asymmetry (like potential long-run benefits of strong activity).

The paper emphasizes the role of the natural rate hypothesis in amplifying these effects. Analysis suggests that central banks should revise preferences toward relatively symmetric treatment of activity to avoid unintended distortions. Financial markets, labor market dynamics, and heterodox policies remain important considerations.

Key policy implications highlight the tension between shortfalls-focused approaches and the need for a balanced framework, provided through rules or more conservative mandates, as asymmetric policies may worsen economic outcomes. Further research exploring long-run hysteresis effects could refine these conclusions.