Optimal Inflation Targeting Rules

This paper characterizes optimal monetary policy for a range of alternative economic models, applying the general theory developed in Giannoni and Woodford (2002a). The rules computed here have the advantage of being optimal regardless of the assumed character of exogenous additive disturbances, though other aspects of model specification do affect the form of the optimal rule. In each case, optimal policy can be implemented through a flexible inflation targeting rule, under which the central bank is committed to adjust its interest-rate instrument so as to ensure that projections of inflation and other variables satisfy a target criterion. The paper shows which additional variables should be taken into account, in addition to the inflation projection, and to what extent, for any given parameterization of the structural equations. It also explains what relative weights should be placed on projections for different horizons in the target criterion, and the manner and degree to which the target criterion should be history-dependent. 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 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. ∗This is a revised draft of a paper prepared for the NBER conference on Inflation Targeting, Miami, Florida, January 23-25, 2003. We would like to thank Jean Boivin, Rick Mishkin, Ed Nelson, and Lars Svensson for helpful discussions, Brad Strum for research assistance, and the National Science Foundation for research support through a grant to the NBER. An increasingly popular approach to the conduct of monetary policy, since the early 1990s, has been inflation-forecast targeting. Under this general approach, a central bank is 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 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 matter — and 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 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 economy, and the other of which (a “specific targeting rule”) involves specification of a target criterion. We are here concerned solely with policy prescriptions of the latter sort. On the implementation of optimal policy through a “general targeting rule,” see Svensson and Woodford (2003).