Lars E.O. Svensson, Princeton University, CEPR and NBER
First draft: June 2004
This version: February 2005
International Journal of Central Banking 1(1) (2005) 1-54
“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 complicated infinite-horizon central-bank projection model of the economy can be closely approximated by a simple finite system of linear equations, which is easily solved for the optimal policy projections. 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 complicated 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
Keywords: Inflation targeting, optimal monetary policy, forecasts.