This paper investigates the implications of a potential loss of credibility in the central bank’s ability to bring inflation back to target in the medium-term (”de-anchoring”). We propose a monetary policy framework in which the central bank accounts for de-anchoring risks using a regime-switching model. First, we derive the optimal monetary policy strategy, which balances the trade-off between the welfare costs of a stronger response to inflation and the benefits of preserving the central bank’s credibility. Next, we apply this framework in a medium-scale regime-switching DSGE model and develop a method to assess de-anchoring risks in real time. Using the post-COVID inflation episode in the euro area as a case study, we find that an explicit ”looking-through” strategy would have only modestly increased de-anchoring risks. These findings highlight the importance of monitoring de-anchoring risks in monetary policy design.
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