Inflation Targeting and Nonlinear Policy Rules: The Case of Asymmetric Preferences (new title: The Fed's monetary policy rule and U.S. inflation: The case of asymmetric preferences)



1 Introduction

A popular method of monetary model building is to regard policy interventions as the solution
of an optimal control problem in which the central bank minimizes some quadratic criterion
subject to a linear structure of the economy. The quadratic characteristic of the ob jective
and the linear feature of the constraints give rise to a linear first order condition that de-
scribes the optimal response of the central bank to the developments in the economy. While
the quadratic specification implies that the monetary authorities evenly weight positive and
negative deviations of inflation and output from the target values, such a modeling choice has
been questioned by several practitioners at the policy committees of various central banks on
the ground that it has little justification beyond analytical tractability.1

Blinder (1997, p. 6) argues that ’academic macroeconomists tend to use quadratic loss func-
tions for reason of mathematical convenience, without thinking much about their substantive
implications. The assumption is not innocuous, [...] practical central bankers and academics
would benefit from more serious thinking about the functional form of the loss function
’. De-
scribing his experience as Fed vice-Chairman Blinder (1998, pp. 19-20) pushes the argument
even further and claims ’
in most situations the central bank will take far more political heat
when it tightens pre-emptively to avoid higher inflation than when it eases pre-emptively to
avoid higher unemployment
’, suggesting that political pressures can induce asymmetric cen-
tral bank interventions. Similar concerns appear to emerge also at other central banks like the
ECB and in the occasion of an interest rate cut of 50 point basis Duisenberg (2001) states ’
the
maintenance of price stability remains our first priority. [...] today’s action could be taken
”without prejudice to price stability”, and it thereby supported the other goals of EMU, such
as economic growth
’.

On the theoretical side, a number of recent studies explore some novel mechanisms through
which the costs of the business cycle can be asymmetric. Persson and Tabellini (1999) combine
retrospective voting with imperfect information about the incumbent’s talent to show that
career concerned politicians can make reappointment more likely by endowing the central bank
with an asymmetric objective that requires a larger monetary policy response in periods of
1 Notable exceptions include Rotemberg and Woodford (1999) and Woodford (2003, ch. 6), who show that
the quadratic form can be obtained as a second order approximation of the representative agent’s utility.



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