Parameter uncertainty and inflation dynamics in a model with asymmetric central bank preferences

This paper builds on the Lucas' (1973) signal extraction model to study the time-varying effect of uncertainty in the output-inflation trade-off on inflation, using a monetary model with asymmetric central bank preferences whereby deviations of output (relative to target) from above are weighted differently from deviations from below. The model is investigated empirically using data from the South African Reserve Bank (SARB). We show that the implication of the uncertainty element is to cause the authority to change its indirect control, output by less (and hence change it direct control, interest rate by less) whenever inflation is below or above the target, in line with Brainard's attenuation principle. We also find that SARB's asymmetric output stabilization explains inflation movements significantly, and that the monetary authority seems to be more averse to business cycle recessions than expansions, hence more keen to avoid recessions than expansions. Overall, a more transparent and committed monetary policy practice that would reduce uncertainty over the output-inflation trade-off would be helpful for economic stability.