Implications of Inflation Forecast Targeting for Fiscal Policy

Many central banks, such as the ECB, explicitly tie monetary policy decisions to medium-term inflation forecasts. Standard New Keynesian models, however, typically abstract from this feature. This paper studies equilibrium determinacy in a New Keynesian model in which monetary policy targets inflation at a forecast horizon larger than one. When policy reacts to sufficiently distant inflation expectations, it may fail to pin down a unique equilibrium. In fact, stronger reactions to expected inflation can make indeterminacy more likely. Whether monetary policy can achieve determinacy at a given forecast horizon depends not only on satisfying the Taylor principle, which provides a lower bound on the inflation coefficient, but also on an upper bound. This upper bound becomes more restrictive as the forecast horizon increases, until determinacy becomes impossible, and depends critically on the slope of the New Keynesian Phillips curve. A sufficiently flat Phillips curve preserves a non-empty determinacy region even at longer forecast horizons. Introducing fiscal policy can restore determinacy across all forecast-horizon targets by ensuring a unique stationary equilibrium. However, this holds only if fiscal policy does not actively stabilize government debt, which implies that inflation forecast targeting at medium horizons puts monetary policy in a passive position and invites fiscal dominance.