Evaluating monetary policy rules under fundamental uncertainty: An info-gap approach

Abstract

Monetary transmission mechanisms after the financial crisis are poorly understood. This implies that monetary policy decisions are made under very high and immeasurable uncertainty. We evaluate alternative Taylor rules that reflect different views, assuming fundamental uncertainty on the parameters and shocks. Rather than selecting rules based on their econometric fit, we apply info-gap theory to rank the rules according to a different criterion: the trade-off between robustness to uncertainty and performance. We find that in the euro area a standard Taylor rule, based on a traditional and well understood macroeconomic model, outperforms more complicated rules that include a credit spread or a debt-to-GDP ratio. It implies that monetary policy that refrains from aiming at financial stability is most robust to uncertainty.