How Costly Will Reining in Inflation Be? It Depends on How Rational We Are

Abstract

We document that past highly inflationary episodes are often characterized by a steeper inflationslack relationship. We show that model-generated data from a standard small Dynamic Stochastic General Equilibrium (DSGE) model can replicate this empirical finding when estimated with different expectation formation processes. When inflation becomes de-anchored and expectations drift, we can observe high inflation even with a mildly positive output gap in response to cost-push shocks. The results imply that we should not use an unconditioned (not controlling for expectations change) Phillips curve estimated in normal times to predict the cost of reining in inflation. Our optimal policy exercises prescribe early monetary policy tightening and then easing in the context of positive output gaps and inflation far above the central bank target.

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