Abstract: We outline a method to provide advice on optimal monetary policy while
taking policymakers' judgment into account. The method constructs optimal
policy projections (OPPs) by extracting the judgment terms that allow a
model, such as the Federal Reserve Board staff economic model, FRB/US, to
reproduce a forecast, such as the Greenbook forecast. Given an intertemporal
loss function that represents monetary policy objectives, OPPs are the
projections---of target variables, instruments, and other variables of
interest---that minimize that loss function for given judgment terms. The
method is illustrated by revisiting the economy of early 1997 as seen in the
Greenbook forecasts of February 1997 and November 1999. In both cases, we
use the vintage of the FRB/US model that was in place at that time. These
two particular forecasts were chosen, in part, because they were at the
beginning and the peak, respectively, of the late 1990s boom period. As
such, they differ markedly in their implied judgments of the state of the
world in 1997 and our OPPs illustrate this difference. For a conventional
loss function, our OPPs provide significantly better performance than
Taylor-rule simulations.
Keywords: Optimal monetary policy, forecasts, judgment
Full paper (352 KB PDF)
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