Optimal Policy Projections
Lars E.O. Svensson (Princeton University) and Robert J. Tetlow (Federal Reserve Board)
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.
JEL Codes: E52, E58.
Full article (PDF, 31 pages 509 kb)