Academic journal article Economic Review (Kansas City, MO)

The Role of Forecasts in Monetary Policy

Academic journal article Economic Review (Kansas City, MO)

The Role of Forecasts in Monetary Policy

Article excerpt

Forecasts of future economic developments play an important role for the monetary policy decisions of central banks. In the United States, for example, at every meeting of the Federal Open Market Committee (FOMC), the staff of the Board of Governors of the Federal Reserve present forecasts for inflation, output growth, and a range of other variables that give policymakers essential information for monetary policy decisions.

This article argues that forecasts of goal variables can help central banks achieve their goals and make them more accountable to the public. The article provides two explanations for the benefits of forecasts. The first explanation is that monetary policy affects goal variables such as inflation and output only with substantial lags. Policy actions should, therefore, be based on forecasts of goal variables at horizons consistent with policy lags and be taken when these forecasts are inconsistent with policy goals. Under such an approach, the quality of a central bank's forecasts and the effectiveness of its actions to bring forecasts into alignment with targets provide a basis for judging the performance of policymakers and for holding them accountable.

The second, and less intuitive, explanation is that by focusing on a forecast of only one variable--inflation--a central bank can potentially achieve multiple goals. This approach can be successful even if there are tradeoffs among the various goal variables. For example, the approach can combine a commitment to long-run price stability with concern for the effects of monetary policy on output.

This approach to monetary policy is consistent with the recent practice in a number of countries of assigning the central bank a single goal of maintaining price stability. The approach also potentially makes it easier to assess the performance of the central bank and thereby hold it accountable. In particular, judging the performance of a central bank that has been assigned the stabilization of a single variable as its sole objective is easier than judging the performance of a central bank with multiple and, possibly, conflicting stabilization goals.

The first section of the article argues that the lagged effects of monetary policy make the use of forecasts necessary. The second section argues that delegating a single goal--such as inflation stabilization--to the central bank facilitates accountability, but at the risk of not achieving other goals. The section then examines how the Eurosystem and the Bank of England, both of which have been assigned a single goal, address the existence of tradeoffs among goals. The third section provides evidence that a monetary policy aimed primarily at stabilizing inflation forecasts--as practiced by the Bank of England, for example--can, in fact, achieve multiple goals.

I. LAGGED EFFECTS OF POLICY AS A RATIONALE FOR FORECASTS

Because monetary policy affects goal variables such as inflation and output with considerable lags, central banks cannot stabilize these variables at very short horizons in the presence of unanticipated shocks. They can, however, take actions today to influence goal variables at the forecast horizon consistent with policy lags. And, these actions can bring forecasts of goal variables into alignment with targets. Thus, while central banks cannot be held accountable for stabilizing all fluctuations in goal variables, they can be held accountable for stabilizing forecasts of goal variables at an appropriate horizon.

The goals of monetary policy

The primary goals of monetary policy are low and stable inflation and sustainable economic growth. The average level of inflation should be low because inflation is harmful to the economy, even if it is constant and perfectly anticipated. Inflation variability should also be low because unanticipated inflation is particularly damaging. For example, when inflation is highly variable--and therefore unpredictable--firms are prone to make errors in their pricing decisions, which are based in part on expected future conditions. …

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