The role of forecasts in monetary policy

Forecasts of future economic developments play an important role for the monetary policy decisions of central banks. For example, forecasts of goal variables can help central banks achieve their goals and make them more accountable to the public. There are two primary explanations for the benefits of forecasts. The first is that monetary policy affects goal variables such as inflation and output only with substantial lags. Policy actions should, therefore, be based on forecasts of goal variables at horizons consistent with policy lags and be taken when these forecasts are inconsistent with policy goals. Under such an approach, the quality of a central bank's forecasts and the effectiveness of its actions to bring forecasts into alignment with targets provide a basis for judging the performance of policymakers and for holding them accountable.> The second, and less intuitive, explanation is that by focusing on a forecast of only one variable -- inflation -- a central bank can potentially achieve multiple goals. This approach can be successful even if there are tradeoffs among the various goal variables. For example, the approach can combine a commitment to long-run price stability with concern for the effects of monetary policy on output.> Amato and Laubach argue that the lagged effects of monetary policy make the use of forecasts necessary. They also argue that delegating a single goal?such as inflation stabilization?to the central bank facilitates accountability, but at the risk of not achieving other goals. They then examine how the Eurosystem and the Bank of England, both of which have been assigned a single goal, address the existence of tradeoffs among goals. Finally, the authors provide evidence that a monetary policy aimed primarily at stabilizing inflation forecasts?as practiced by the Bank of England, for example?can, in fact, achieve multiple goals.