The Optimal Monetary Policy Response to Belief Distortions: Model-Free Evidence

Some inflation forecast errors are predictable. Economic theory predicts that these belief distortions affect the business cycle. How should monetary policy respond? We investigate this question with a model-free approach using high-frequency monetary policy shocks and a structural VAR method to identify the effects of shocks to belief distortions. Belief distortion shocks are contractionary: if households become overly pessimistic about inflation, then unemployment and deflation follow. Intuitively, the optimal policy response is to ease. This is most effective with short-term rates; we find that a 1 p.p. increase in the belief distortion is optimally offset by a 0.85 p.p. surprise interest rate decrease. Monetary policy targeting longer-term rates is less effective but also useful.