Academic journal article Journal of Money, Credit & Banking

Comment on 'Inflation Forecasts and Monetary Policy.'(response to Article in This Issue, P. 653) (Dynamic Effects of Monetary Policy)

Academic journal article Journal of Money, Credit & Banking

Comment on 'Inflation Forecasts and Monetary Policy.'(response to Article in This Issue, P. 653) (Dynamic Effects of Monetary Policy)

Article excerpt

This paper addresses an important question regarding the conduct of monetary policy. How should central banks use private forecasts of such target variables as inflation in setting policy instruments like short-term interest rates. The answer is: With great caution. Several authors including Goodfriend (1993), Hall and Mankiw (1994), and Hetzel (1990 and 1992) have proposed that measures of private-sector forecasts be used in the conduct of monetary policy. Two arguments have been made in support of these proposals. First, private agents may have information about variables that affect the economy which the central bank could use in making its decisions. Second, private agents may be able to detect deviations from policy rules that depend explicitly upon market prices and this could ensure that the central bank is held sharply accountable for its decisions. For example, asset market prices could be used to judge whether central banks are doing a good job.

Bernanke and Woodford show that naive rules that use private sector forecasts can lead to undesirable outcomes. The logic is simple and beautiful. Suppose, for instance, that the central bank wants to stabilize inflation rates and private forecasters have information that is not available to the central bank about future inflation. The central bank could use private forecasts of inflation to choose its policy instrument. The problem is that if the central bank is completely effective in using its policy instrument to stabilize inflation, private forecasts of inflation should rationally be the central bank's inflation target in which case, private forecasts provide no information about inflation! This paradox arises because market forecasts of a goal variable depend upon the central bank's policy rule and if the central bank uses the information well, market forecasts will not be informative. …

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