European Central Bank publishes working paper proposing risk-adjusted inflation targeting to counter asymmetric inflation risks

The European Central Bank published a working paper by Andrea De Polis, Leonardo Melosi and Ivan Petrella that documents time-varying and often asymmetric inflation risk in the United States and examines how monetary policy should respond when the balance of inflation risks is tilted to the upside or downside. Within a general-equilibrium model that represents skewed shock distributions via a tractable “beliefs representation”, the paper finds that optimal policy requires shifting agents’ inflation expectations in the opposite direction of the prevailing skew and proposes “Risk-Adjusted Inflation Targeting” (RAIT) as a strategy that uses real-time risk assessments to guide policy and communication. On the empirical side, the authors estimate the predictive density of US core personal consumption expenditures inflation using a skew-t framework with time-varying mean, volatility and skewness, formally rejecting constant skewness and finding frequent, persistent shifts in the balance of risks. Incorporating time-varying skewness improves out-of-sample forecast performance relative to benchmark models and achieves predictive accuracy comparable to the Survey of Professional Forecasters. In counterfactual comparisons with the Federal Reserve’s flexible average inflation targeting, RAIT would have looked through the apparent deflationary bias of the 2010s given low inflation volatility, while during the recent inflation surge it would have recommended a similar magnitude of rate increases but with an earlier start to tightening and earlier rate reductions as inflation risks stabilised.