Robust Monetary Policy with Misspecified Models: Does Model Uncertainty Always Call for Attenuated Policy?

We explore Knightian model uncertainty as an explanation for the observed excess persistence and attenuation in estimated interest-rate reaction functions for the United States, relative to what optimal feedback rules would suggest. Two types of uncertainty are identified: (i) unstructured model uncertainty captured in additive shock error processes that result from omitted-variable misspecifications, and (ii) structured model uncertainty, where one or more parameters are posited as the source of misspecification. We estimate a forward-looking model of the U.S. economy, and find that rules for this model that are robust against unstructured model uncertainty, or against one-time parametric shifts, are more aggressive than the optimal linear quadratic rule. However, policies designed to protect the economy against the worst-case consequences of misspecified dynamics are less aggressive and good approximations of the estimated rule. Some drawbacks of robust policies are discussed. Finally, a connection between the degree of structure an authority ascribes to the uncertainty it faces and the extent and likelihood of policy attenuation in response to that uncertainty is explored.