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.