Challenges for Monetary Policy1

Good monetary policy is both simple and complicated. The principles for good monetary policy are simple: Perform flexible inflation targeting, which means aiming to stabilize inflation around an explicit low positive numerical inflation target with some weight also on stabilizing the output gap, that is, stabilizing output around a measure of potential output. Because of the lags between monetary-policy actions and the effect on inflation and output, the way to do this is to look forward and perform forecast targeting, that is, to set the central bank's instrument rate such that the inflation and the output-gap forecasts " look good, " which means that the inflation and output-gap forecasts approach the inflation target and zero, respectively, some 1—3 years ahead. The practice of constructing these forecasts and deciding on the appropriate instrument rate (or rather, instrument-rate plan) is quite complicated, though, and requires the collection and processing of vast amounts of data, thorough analysis, and skillful combination of judgment and model results. Since monetary policy works via the expectations of future instrument-rate settings rather than the current instrument rate, and since expectations of future inflation and output matter for the private sector's current pricing and production decisions, monetary policy is to a large extent the management of expectations. Therefore, the transparency and public understanding of monetary policy, including the inflation and output-gap forecast that guide it, increase the effectiveness of monetary policy; the explicit inflation target also provides an effective anchor for inflation expectations. Explicit objectives and transparency are also important for the accountability of central banks, which is of independent value in a democracy but also provides stronger incentives for central banks to achieve their objectives. Interestingly, central banks in a few small and medium-sized countries have been leading monetary-policy developments in the past decade and have come to represent international best practice, for instance, the Reserve Bank of New Zealand, the Bank of England, and Sweden's Riksbank, and an increasing number of central banks in other countries have chosen to follow their leads. In contrast, the central banks in the G3 are lagging behind in this development– although they may follow internal procedures similar to forecast targeting with internal objectives not disclosed to the general public. The ECB–although having recently improved its definition of price stability and reduced the role of monetary aggregates–has chosen to be less transparent, for instance, in its publishing of forecasts. The Fed and …