Optimal Inflation Targeting Rules

Abstract

This paper characterizes optimal monetary policy for a range of alternative economic models in terms of a flexible inflation targeting rule, with a target criterion that depends on the model specification. It shows which forecast horizons should matter, and which variables besides inflation should be taken into account, for each specification.The likely quantitative significance of the various factors considered in the general discussion is then assessed by estimating a small, structural model of the U.S. monetary transmission mechanism with explicit optimizing foundations. An optimal policy rule is computed for the estimated model, and shown to correspond to a multi-stage inflation-forecast targeting procedure.The degree to which actual U.S. policy over the past two decades has conformed to the optimal target criteria is then considered. committed to adjust short-term nominal interest rates periodically so as to ensure that its projection for the economy's evolution satisfies an explicit target criterion -for example, in the case of the Bank of England, the requirement that the RPIX inflation rate be projected to equal 2.5 percent at a horizon two years in the future (Vickers, 1998). Such a commitment can overcome the inflationary bias that is likely to follow from discretionary policy guided solely by a concern for social welfare, and can also help to stabilize medium-term inflation expectations around a level that reduces the output cost to the economy of maintaining low inflation.Another benefit that is claimed for such an approach (e.g., King, 1997; Bernanke et al., 1999)-and an important advantage, at least in principle, of inflation targeting over other policy rules, such as a k-percent rule for monetary growth, that should also achieve a low average rate of inflation -is the possibility of combining reasonable stability of the inflation rate (especially over the medium to long term) with optimal short-run responses to real disturbances of various sorts. Hence Svensson (1999) argues for the desirability of "flexible" inflation targeting, by which it is meant 1 that the target criterion involves not only the projected path of the inflation rate, but one or more other variables, such as a measure of the output gap, as well.We here consider the question of what sort of additional variables ought to matterand with what weights, and what dynamic structure -in a target criterion that is intended to implement optimal policy. We wish to use economic theory to address questions such as which measure of inflation is most appropriately targeted (an index of goods prices only, or wage inflation as well?), which sort of output gap, if any, should justify short-run departures of projected inflation from the long-run target rate (a departure of real GDP from a smooth 1 Svensson discusses two alternative specifications of an inflation-targeting policy rule, one of which (a "general targeting rule") involves specification of a loss function that the central bank should use to evaluate alternative paths for the e...

Estimating Regime-Switching Taylor Rules with Trend Inflation

“…The literature has o¤ered a variety of point estimates for the indexation parameter, ranging from zero (Cogley and Sbordone (2005), Cogley and Sbordone (2007)) to values close to one (Giannoni and Woodford (2003)). We leave the estimation of a regime-switching framework conditional on the modi…ed Taylor principle as in Ascari and Ropele (2007b) to future research.…”

Asymmetric Expectation Effects of Regime Shifts and the Great Moderation

“…Equation (36) generalizes the standard Phillips curve by introducing partial indexation and, more importantly, regime-dependent frequencies of price adjustments and ination indexation. In the special case where η t =η and γ t = γ for all t, this equation reduces to the standard Phillips curve relation with partial indexation as in Woodford (2003) and Giannoni and Woodford (2003) (augmented with habit formation). If we further impose that γ = 0 and b = 0 so that there is no indexation and no habit formation, then (36) collapses to the pure forward-looking Phillips-curve relation with the real marginal cost represented by a deviation of output from its trend.…”

Revisiting the Great Moderation: Policy or Luck?

“…); with lower the latter implies a much ‡atter Phillips curve. The estimation also suggests the Fed had a low relative weight on output variations ( ) pre-1982 but that high nominal rigidity forced it to reduce in ‡ation more strongly in response to 18 We …x the time discount factor and the steady-state consumption-output ratio C Y as calibrated; other parameters are allowed to vary within 50% of the calibrated values-which are set as initial values here-unless stated otherwise. 19 It could be argued that deep parameters such as the elasticity of intertemporal substitution and Calvo price-change probabilities should remain …xed across the two periods.…”

“…Accordingly we now allow the model parameters to be altered to achieve for each model the lowest Wald possible, subject to the theoretical ranges permitted by the model theory 18 . This estimation method is that of Indirect Inference; we use the Simulated Annealing (SA) algorithm for the parameter search, as discussed above in section 4.…”

“…We allow each rule/model combination to be calibrated with the best chance of matching the data and then test on that best calibration, using the method of Indirect Inference under which the model's simulated behaviour is 1 Rules of the Taylor type are generally found to …t the data well, either as a stand-alone equation in regression analysis, or as part of a full model in DSGE analysis. Giannoni and Woodford (2005) is a recent example of the former, whereas Smets and Wouters (2007) and Ireland (2007) are examples of the latter. However, besides the usual di¢ culties encountered in applied work (e.g., Castelnuovo, 2003 andCarare andTchaidze, 2005), these estimates face an identi…cation problem pointed out by Minford, Perugini and Srinivasan (2002) and Cochrane (2011).…”