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Monetary policy with judgment: forecast targeting

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  • Svensson, Lars E. O.

Abstract

“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 U.S. economy, one forward looking and one backward looking. A practical finite-horizon approximation is used. 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. JEL Classification: E42, E52, E58

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Bibliographic Info

Paper provided by European Central Bank in its series Working Paper Series with number 0476.

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Date of creation: Apr 2005
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Handle: RePEc:ecb:ecbwps:20050476

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Keywords: forecasts; inflation targeting; optimal monetary policy;

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  1. Svensson, Lars E.O. & Rudebusch , Glenn, 1998. "Policy Rules for Inflation Targeting," Seminar Papers 637, Stockholm University, Institute for International Economic Studies.
  2. Svensson, Lars E. O. & Woodford, Michael, 2000. "Indicator variables for optimal policy," Working Paper Series 0012, European Central Bank.
  3. Klein, Paul, 2000. "Using the generalized Schur form to solve a multivariate linear rational expectations model," Journal of Economic Dynamics and Control, Elsevier, vol. 24(10), pages 1405-1423, September.
  4. Lars Svensson & Noah Williams, 2005. "Monetary Policy with Model Uncertainty: Distribution Forecast Targeting," NBER Working Papers 11733, National Bureau of Economic Research, Inc.
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  7. Lars E.O. Svensson, 2004. "Targeting Rules vs. Instrument Rules for Monetary Policy: What is Wrong with McCallum and Nelson?," NBER Working Papers 10747, National Bureau of Economic Research, Inc.
  8. Lars E. O. Svensson, 2003. "What is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules," NBER Working Papers 9421, National Bureau of Economic Research, Inc.
  9. Svensson, Lars E.O., 1998. "Inflation Targeting as a Monetary Policy Rule," Seminar Papers 646, Stockholm University, Institute for International Economic Studies.
  10. Bennett T. McCallum & Edward Nelson, 2004. "Targeting vs. instrument rules for monetary policy," Working Papers 2004-011, Federal Reserve Bank of St. Louis.
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  19. Söderlind, Paul, 1998. "Solution and Estimation of RE Macromodels with Optimal Policy," Working Paper Series in Economics and Finance 256, Stockholm School of Economics.
  20. Marc P. Giannoni & Michael Woodford, 2003. "Optimal Interest-Rate Rules: I. General Theory," NBER Working Papers 9419, National Bureau of Economic Research, Inc.
  21. Lars E.O. Svensson & Robert J. Tetlow, 2005. "Optimal policy projections," Finance and Economics Discussion Series 2005-34, Board of Governors of the Federal Reserve System (U.S.).
  22. Stephen Morris & Hyun Song Shin, 2002. "Social Value of Public Information," American Economic Review, American Economic Association, vol. 92(5), pages 1521-1534, December.
  23. Alan Greenspan, 2004. "Risk and Uncertainty in Monetary Policy," American Economic Review, American Economic Association, vol. 94(2), pages 33-40, May.
  24. Christopher A. Sims, 2002. "The Role of Models and Probabilities in the Monetary Policy Process," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 33(2), pages 1-62.
  25. Sharon Kozicki, 1999. "How useful are Taylor rules for monetary policy?," Economic Review, Federal Reserve Bank of Kansas City, issue Q II, pages 5-33.
  26. Lars E.O. Svensson & Kjetil Houg & Haakon O.Aa. Solheim & Erling Steigum, 2002. "An Independent Review of Monetary Policy and Institutions in Norway," Working Papers 120, Princeton University, Department of Economics, Center for Economic Policy Studies..
  27. Petra M. Geraats, 2002. "Central Bank Transparency," Economic Journal, Royal Economic Society, vol. 112(483), pages 532-565, November.
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