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The Inflation Forecast and the Loss Function

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  • Svensson, Lars E O

Abstract

This Paper argues that inflation-targeting central banks should announce explicit loss function with numerical relative weights on output-gap stabilization and use and announce optimal time-varying instrument-rate paths and corresponding inflation and output-gap forecasts. Simple voting procedures for forming the Monetary Policy Committee’s aggregate loss function and time-varying instrument-rate paths are suggested. Announcing an explicit loss function improves the transparency of inflation targeting and eliminates some misunderstandings of the meaning of ‘flexible’ inflation targeting. Using time-varying instrument-rate paths avoids a number of inconsistencies and other problems inherently associated with constant-interest-rate forecasts.

Suggested Citation

  • Svensson, Lars E O, 2002. "The Inflation Forecast and the Loss Function," CEPR Discussion Papers 3365, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:3365
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    References listed on IDEAS

    as
    1. Michael Woodford, 1999. "Commentary : how should monetary policy be conducted in an era of price stability?," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 277-316.
    2. Persson, Torsten & Tabellini, Guido, 1999. "Political economics and macroeconomic policy," Handbook of Macroeconomics,in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 22, pages 1397-1482 Elsevier.
    3. repec:sae:niesru:v:167:y::i:1:p:106-112 is not listed on IDEAS
    4. Nicoletta Batini & Andrew Haldane, 1999. "Forward-Looking Rules for Monetary Policy," NBER Chapters,in: Monetary Policy Rules, pages 157-202 National Bureau of Economic Research, Inc.
    5. Lars E.O. Svensson & Michael Woodford, 2004. "Implementing Optimal Policy through Inflation-Forecast Targeting," NBER Chapters,in: The Inflation-Targeting Debate, pages 19-92 National Bureau of Economic Research, Inc.
    6. Ruge-Murcia, Francisco J, 2003. " Inflation Targeting under Asymmetric Preferences," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 35(5), pages 763-785, October.
    7. Nessen, Marianne & Vestin, David, 2005. "Average Inflation Targeting," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 37(5), pages 837-863, October.
    8. Svensson, Lars E O, 1999. "Price Stability as a Target for Monetary Policy: Defining and Maintaining Price Stability," CEPR Discussion Papers 2196, C.E.P.R. Discussion Papers.
    9. Bennett T. McCallum & Edward Nelson, 1999. "Performance of Operational Policy Rules in an Estimated Semiclassical Structural Model," NBER Chapters,in: Monetary Policy Rules, pages 15-56 National Bureau of Economic Research, Inc.
    10. Professor Lars E O Svensson, 2001. "Independent review of the operation of monetary policy in New Zealand," Reserve Bank of New Zealand Bulletin, Reserve Bank of New Zealand, vol. 64, March.
    11. Lars E. O. Svensson, 2003. "What Is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules," Journal of Economic Literature, American Economic Association, vol. 41(2), pages 426-477, June.
    12. Woodford Michael, 2002. "Inflation Stabilization and Welfare," The B.E. Journal of Macroeconomics, De Gruyter, vol. 2(1), pages 1-53, February.
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    17. Gilles Oudiz & Jeffrey Sachs, 1985. "International Policy Coordination in Dynamic Macroeconomic Models," NBER Chapters,in: International Economic Policy Coordination, pages 274-330 National Bureau of Economic Research, Inc.
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    Citations

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    Cited by:

    1. Daniel L. Thornton, 2003. "Monetary policy transparency: transparent about what?," Manchester School, University of Manchester, vol. 71(5), pages 478-497, September.
    2. Lars E. O. Svensson, 2002. "Monetary policy and real stabilization," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 261-312.
    3. Paolo Surico, 2003. "How does the ECB target inflation?," Macroeconomics 0305005, EconWPA.
    4. Lavan Mahadeva & Alex Muscatelli, 2005. "National Accounts Revisions and Output Gap Estimates in a Model of Monetary Policy with Data Uncertainty," Discussion Papers 14, Monetary Policy Committee Unit, Bank of England.
    5. Laxton, Douglas & Pesenti, Paolo & Juillard, Michel & Karam, Philippe, 2006. "Welfare-based monetary policy rules in an estimated DSGE model of the US economy," Working Paper Series 613, European Central Bank.
    6. Lars E. O. Svensson, 2005. "Targeting versus instrument rules for monetary policy: what is wrong with McCallum and Nelson?," Review, Federal Reserve Bank of St. Louis, issue Sep, pages 613-626.
    7. Lars E. O. Svensson, 2003. "Monetary policy and learning," Economic Review, Federal Reserve Bank of Atlanta, issue Q3, pages 11-16.
    8. Juan Paez-Farrell, 2009. "Timeless perspective vs discretionary policymaking when the degree of inflation persistence is unknown," Discussion Paper Series 2009_14, Department of Economics, Loughborough University, revised Sep 2009.
    9. Koppány, Krisztián, 2007. "Likviditási csapda és deflációs spirál egy inflációs célt követő modellben - a hitelesség szerepe
      [A liquidity trap and deflationary spiral in a model for pursuing an inflation target - the role of
      ," Közgazdasági Szemle (Economic Review - monthly of the Hungarian Academy of Sciences), Közgazdasági Szemle Alapítvány (Economic Review Foundation), vol. 0(11), pages 974-1003.
    10. 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.
    11. Jérôme Héricourt, 2004. "And if one size fit all after all ? A counterfactual examination of the ECB monetary policy under Duisenberg presidency," Cahiers de la Maison des Sciences Economiques bla04004a, Université Panthéon-Sorbonne (Paris 1), revised Nov 2005.

    More about this item

    Keywords

    inflation targeting; interest rate paths;

    JEL classification:

    • E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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