Inflation Targeting and Target Instability
by Robert J. Tetlow
Board of Governors of the Federal Reserve System
Monetary policy is modeled as being governed by a known
rule, except for a time-varying target rate of inflation. The
variable target can be thought of either as standing in for discretionary
deviations from the rule or as the outcome of a
policymaking committee that is unable to arrive at a consensus.
Stochastic simulations of FRB/US, the Board of Governorsí
large rational-expectations model of the U.S. economy,
are used to examine the benefits of reducing the variability
in the target rate of inflation. We find that putting credible
boundaries on target variability introduces an important nonlinearity
in expectations. The effect of this is to improve policy
performance by focusing agentsí expectations on policy objectives.
But improvements are limited; it does not generally pay
to reduce target variability to zero. More important, this nonlinearity
in expectations allows for policy to be conducted, at
the margin, with greater attention to output stabilization than
would otherwise be the case. The results provide insights as to
why inflation-targeting countries use bands and why the bands
they use are narrower than studies suggest they should be. A
side benefit of the paper is the demonstration of a numerical
technique that approximates to arbitrary precision a nonlinear
process with a linear method, thereby greatly speeding and
making more robust the computation of simulation results.
JEL Codes: E3, E5, C6.
(PDF, 42 pages 562 kb)