Working Paper no. 95: Online Monitoring of Policy Optimality

The Central Bank of Iceland has published the working paper "Online Monitoring of Policy Optimality" by Bjarni G. Einarsson, economist in the department of Economics and Monetary Policy.

The paper presents a method for online evaluation of the optimality of the current stance of monetary policy given the most up to date data available. The framework combines estimates of the causal effects of monetary policy tools on inflation and the unemployment gap with forecasts for these target variables. The forecasts are generated with a nowcasting model, incorporating new data as it becomes available, while using entropy tilting to anchor the long end of the forecast at long run survey expectations. In a retrospective analysis of the Fed's monetary policy decisions in the lead up to the Great Recession the paper finds rejections of the optimality of the policy stance as early as the beginning of February 2008. This early detection stems from the timely nowcasting of the deteriorating unemployment outlook.

The working paper by Bjarni G. Einarsson can be accessed here: Online Monitoring of Policy Optimality