Optimal monetary policy with uncertain private sector foresight

• Published in: Journal of monetary economics p. 103826
• Main Authors: Gust, Christopher, Herbst, Edward, López-Salido, David
• Format: Journal Article
• Language: English
• Published: Elsevier B.V 01.08.2025
• Subjects: Finite-horizon planning; Optimal monetary policy under uncertainty; C11; E52; Finite-horizon planning; E70; Optimal monetary policy under uncertainty
• ISSN: 0304-3932
• DOI: 10.1016/j.jmoneco.2025.103826

We model private-sector expectations in a finite-horizon-planning framework: households and firms have limited foresight when making spending, saving, and pricing decisions. In this setting, contrary to standard New Keynesian (NK) models, we show that an “inflation scare” problem can arise in which agents’ longer-run inflation expectations deviate persistently from a central bank’s inflation target. We characterize optimal time-consistent monetary policy when there is uncertainty about the planning horizons of private sector agents and a risk of inflation scares. We show how risk-management considerations modify the optimal “leaning-against-the-wind” principle in the NK literature with a novel, additional preemptive motive to avert inflation scares. •Central banks operate in an environment of substantial uncertainty.•When households and firms have limited foresight, longer-run inflation expectations can deviate from a central bank’s inflation target.•When a central bank is uncertain about the foresight of households and firms, the optimal monetary policy is more aggressive in responding to inflation.•A more aggressive response reduces the risk of persistent deviations in longer-run inflation expectations from the central bank’s inflation target.