Requiem for Forecast-Based Instrument Rules
Lars E.O. Svensson
CEPR and NBER
Frequently used so-called forecast-based instrument rules are shown to correspond to a problematic intertemporal loss function. This loss function is problematic because it is time-inconsistent, arbitrary, and (for the most common form of forecast-based instrument rules) does not incorporate any explicit concern for output-gap stability.
The time-inconsistency of the loss function arises because it does not have exponential discounting. This implies that inflation paths that are optimal ex ante will not be realized ex post. This is a source of inefficiency separate from the one discussed in the literature initiated by Kydland and Prescott and by Barro and Gordon.
It follows that forecast-based instrument rules are not consistent with a conventional, intertemporal loss functions corresponding to flexible inflation targeting.
Keywords: Monetary policy rules, inflation targeting
JEL Classification: E52, E58