DP5072 Monetary Policy with Judgement: Forecast Targeting

Author(s): Lars E.O. Svensson
Publication Date: May 2005
Keyword(s): forecasts, inflation targeting, optimal monetary policy
JEL(s): E42, E52, E58
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=5072

?Forecast targeting?, forward-looking monetary policy that uses central-bank judgment to construct optimal policy projections of the target variables and the instrument rate, may perform substantially better than monetary policy that disregards judgment and follows a given instrument rule. This is demonstrated in a few examples for two empirical models of the US economy, one forward looking and one backward looking. A complicated infinite-horizon central bank projection model of the economy can be closely approximated by a simple finite system of linear equations, which is easily solved for the optimal policy projections. Optimal policy projections corresponding to the optimal policy under commitment in a timeless perspective can easily be constructed. The whole projection path of the instrument rate is more important than the current instrument setting. The resulting reduced-form reaction function for the current instrument rate is a very complex function of all inputs in the monetary-policy decision process, including the central bank?s judgment. It cannot be summarized as a simple reaction function such as a Taylor rule. Fortunately, it need not be made explicit.