Targeting Inflation by Constant-Interest-Rate Forecasts

Abstract

The paper reviews the concept of constant-interest-rate inflation forecast targeting employed by several inflation targeting central banks. It provides a new method for constructing such forecasts in the context of models with forward-looking variables. It furthermore explores a standard closed-economy macromodel in the context of forecast targeting. The analysis suggests that the main reason for choosing a relatively long forecast horizon lies in the monetary authorities? objective to smooth interest rate movements and not in order to stabilize inflation and output variability. Astrongly forward-looking inflation process brings the outcome of forecast targeting closer to the optimal discretionary policy, whereas a backward-looking process may lead to model instability.

Keywords: Monetary policy, inflation targeting, forecast targeting

JEL Classification: E37, E43, E52