MACRO: Dr Nicolas Caramp (University of California, Davis)

Sticky Inflation: Monetary Policy when Debt Drags Inflation Expectations

We incorporate the expectation of a potential inflationary-financing event into a standard New Keynesian model. In such an event, monetary policy temporarily resorts to inflating away public debt. The mere anticipation of this possibility links public debt to inflation expectations through the effect of interest rates on the fiscal burden. While disinflation is feasible in the short run, inflation resurges with full force—sticky inflation—as higher debt amplifies the cost of maintaining low inflation. Optimal monetary policy accommodates fiscal shocks with persistently low real interest rates, effectively front-loading inflation and departing from the Taylor principle. We use this framework to interpret the Federal Reserve’s “behind the curve” stance following the COVID-19 pandemic.