Targeting inflation by constant-interest-rate forecasts.

This paper reviews the concept of constant-interest-rate inflation forecast (CIR) targeting. It stresses the time-inconsistent nature of CIR targeting and provides a new method for constructing CIR forecasts consistently in the context of models with forward-looking variables. A dynamic New Keynesian model with forward-looking price setting is used as an illustration, suggesting that the main reason for choosing a relatively long forecast targeting horizon lies in the monetary authorities' objective to smooth interest rate movements, as greater nominal and real stabilization is achieved at a relatively short inflation forecast targeting horizon.

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INFLATION TARGETING is considered to be the new framework for monetary policy of the 1990s. It has sparked off extensive research by both academic scholars and central bank researchers since its introduction in New Zealand in 1990. (1) Inflation targeting has a relatively precise definition as posed by Svensson (1999c). It can be described as a monetary policy framework where the central bank has the deviation of inflation from some specific target level as the main argument in its loss function, and where the bank enjoys instrument independence in minimizing this loss. Transparency with respect to policy formulation, enhancing the accountability of the central bank, is another important aspect of the inflation targeting regime that led Bernanke and Mishkin (1997) to conclude that inflation targeting is a framework of constrained discretion on the part of the central bank. This discretion has arguably led to different ways of implementing the inflation targeting policy.

A host of theoretical as well as empirical papers have stressed the importance of having an inflation targeting policy that is forward-looking. (2) The instruments available to the monetary policymaker are usually assumed to have the largest impact upon the rate of inflation at some horizon. A good policy should therefore react to the underlying determinants of future inflation in order to influence it in a favorable way. Svensson (1997) argues that the rational expectation forecast of inflation is the optimal indicator of these determinants. Targeting the forecast of inflation could therefore come close to the optimal policy in minimizing deviations of inflation from target and in addition offer a procedure that is intuitive. Such a policy can be denoted by