The Taming of the Skew: Asymmetric Inflation Risk and Monetary Policy

Inflation risk in U.S. data varies considerably over time and has often been asymmetric. A model incorporating time-varying asymmetric risk achieves better forecasting accuracy than a state-of-the-art symmetric model, providing results comparable to the performance of profes- sional forecasters. The optimal monetary strategy calls for the Central Bank to counterbalance shifts in the direction of inflation risk by adjusting its inflation target –a strategy we term risk- adjusted inflation targeting (RAIT). By adjusting the modal inflation scenario, the Central Bank can realign average inflation with its desired long-run inflation objective and effectively anchor the private sector’s expectations.