Interest Rate Smoothing in the Face of Energy Shocks

Abstract:

This paper analyzes the monetary policy trade-off between defending purchasing power
of consumers and keeping moderate debt cost for borrowers, in the framework of a
heterogeneous agent New Keynesian open economy hit by a foreign energy price shock.
Raising the interest rate indeed combats the loss in purchasing power due to the energy
shock through a real exchange rate appreciation: however, this comes at the expense
of higher interest payments for debtors. The trade-off can be resolved by adopting a
milder interest rate policy during the crisis in exchange for a prolonged contraction
beyond the energy shock time span. This interest rate smoothing approach allows to
still experience a real appreciation today, while spreading the impact on debt costs
more evenly over time. This policy counterfactual is analyzed in a quantitative model
of the UK economy under the 2022-2023 energy price hike, where the loss of consumers’
purchasing power and the vulnerability of mortgage costs to higher policy rates have been elements of paramount empirical relevance.

Stefano Corbellini, Sheffield University