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.