International Finance Discussion Papers (IFDP)
May 2004
Is Inflation Targeting Best-Practice Monetary Policy?
Jon Faust and Dale W. Henderson
Abstract:
We describe the inflation targeting framework (ITF) and compare it against hypothetical best-practice based on optimization. The core requirements of the ITF are an explicit long-run inflation goal and a commitment to transparency in policymaking. Advocates and practitioners of the ITF have made many contributions to clear goal setting and communication by central banks. However, we contend that ITF communication policies both as advocated and practiced often have some elements that either obfuscate or, in some cases, explicitly contradict the dictates of optimization in a stabilization-policy paradigm. In this paradigm, the central bank has an objective function that places weight on both inflation and output-gap stabilization and faces a conventional (exploitable) Phillips-curve trade-off. We point out some problems that the ITF communication policy may generate in this setting. Our analysis leads us to make four suggestions for communication policy intended to help central banks avoid these problems.
Full paper (screen reader version)Keywords: Rules, discretion, commitment, transparency, communication, forecast, political economy, inflation bias, stabilization bias, trade off, expectations, fixed horizon, optimal policy, simple rule
PDF: Full Paper
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