Forward-Backward-Looking Monetary Policy Rules: Derivation and Empirics

We first propose an analytical framework for monetary policy reaction function that includes both forward and backward aspects. The proposed function is then estimated for Pakistan utilizing quarterly data covering the period 1971Q1-2018Q4. The results reveal that the central bank adjusts interest rates by considering both lead (forward) and lagged (backward) aspects of the underlying variables. Yet, our empirical analysis shows that Pakistan’s central bank gives relatively more weight to future expected inflation, future exchange rates, and the prior period output when setting the interest rate. Finally, we show that the monetary policymakers in Pakistan have asymmetric preferences regarding interest rate setting. Robustness checks show that the findings hold even after controlling for potential structural breaks.