Inflation expectations, uncertainty and monetary policy

Monetary economics as practiced by central bank modelers has made a great deal of progress in recent years. In a 2002 paper I interviewed research economists at four central banks and surveyed the models in use at those banks. I criticized the models for having lost all touch with statistical inference and with its connection to decision theory. I also criticized them for not following the rational expectations literature by jointly specifying and estimating the equations in their systems. And I pointed out that none of the models had a consistent treatment of asset markets. Since then many central banks, taking advantage of the new computational methods for Bayesian inference that economists are learning to use, have made substantial progress toward meeting the first two of these criticisms. They have still for the most part done little about the third. And academic economists are beginning to question some of the standard assumptions in the rational expectations framework that underlies these models.Recent events in financial markets, and the difficulties that they raise for central banks, make it painfully clear that even the frontier Bayesian DSGE models like that in use at the Swedish Riksbank do not model asset markets in any depth. But the problem goes beyond that: these models, and most academic macro models as well, assume a standard rational expectations framework: there is only one probability measure in play, the "true" probability measure from which nature draws realizations. Agents in the model form expectations using this true distribution, conditioning on information sets that consist of all information in the model dated t and earlier. It is well documented that people do not actually behave this way, and in the literature on behavioral finance there is some suggestion that deviations from this standardized assumption of rational behavior given a common probability distribution may be important.The recent events in financial markets - the dotcom boom, the US house price boom, perhaps the conti