Targeting Inflation by Forecast Feedback Rules in Small Open Economies

We argue that inflation-targeting strategy in practice can be approximated with the interest rate responding to the unchanged-interest-rate forecast of inflation. We develop a method to derive unchanged-interest-rate forecasts in forward-looking models and evaluate the performance of the policy rule in an optimizing New Keynesian model due to Monacelli (2003) estimated on UK data. We find that the policy rule is less prone to generate a determinate rational expectations equilibrium if based on an unchanged interest rate compared to the rule-consistent forecast. The rule approximates the optimal commitment policy if the central bank attaches sufficient weight to inflation as opposed to output gap stabilization. The optimal forecast horizon is robustly close to one and a half yearInflation Targeting, monetary policy, feedback rules, open economy

Robust monetary policy in a small open economy

This paper studies how a central bank’s preference for robustness against model misspecification affects the design of monetary policy in a New-Keynesian model of a small open economy. Due to the simple model structure, we are able to solve analytically solve the optimal robust policy rule, and separately ana-lyze the effects of robustness against misspecification concerning the determination of inflation, output and the exchange rate. We show that an increased central bank preference for robustness makes monetary policy respond more aggressively or more cautiously to shocks, depending on the type of shock and the source of misspecification.Knightian uncertainty; model uncertainty; robust control; min-max policies

Robust monetary policy in the New-Keynesian framework

We study the effects of model uncertainty in a simple New-Keynesian model using robust control techniques. Due to the simple model structure, we are able to find closed-form solutions for the robust control problem, analysing both instrument rules and targeting rules under different timing assumptions. In all cases but one, an increased preference for robustness makes monetary policy respond more aggressively to cost shocks but leaves the response to demand shocks unchanged. As a consequence, inflation is less volatile and output is more volatile than under a non-robust policy. Under one particular timing assumption, however, increasing the preference for robustness has no effect on the optimal targeting rule (nor on the economy).Knightian uncertainty; model uncertainty; robust control; min-max policies

Robust monetary policy in the New-Keynesian framework

We study the effects of model uncertainty in a simple New-Keynesian model using robust control techniques. Due to the simple model structure, we are able to find closed-form solutions for the robust control problem, analysing both instrument rules and targeting rules under different timing assumptions. In all cases but one, an increased preference for robustness makes monetary policy respond more aggressively to cost shocks but leaves the response to demand shocks unchanged. As a consequence, inflation is less volatile and output is more volatile than under a non-robust policy. Under one particular timing assumption, however, increasing the preference for robustness has no effect on the optimal targeting rule (nor on the economy).Knightian uncertainty, model uncertainty, robust control, min- max policies

Identifying the interdependence between US monetary policy and the stock market

We estimate the interdependence between US monetary policy and the S&P 500 using structural VAR methodology. A solution is proposed to the simultaneity problem of identifying monetary and stock price shocks by using a combination of short-run and long-run restrictions that maintains the qualitative proper-ties of a monetary policy shock found in the established literature (CEE 1999). We find great interde-pendence between interest rate setting and stock prices. Stock prices immediately fall by 1.5 per cent due to a monetary policy shock that raises the federal funds rate by ten basis points. A stock price shock in-creasing stock prices by one per cent leads to an increase in the interest rate of five basis points. Stock price shocks are orthogonal to the information set in the VAR model and can be interpreted as non-fundamental shocks. We attribute a major part of the surge in stock prices at the end of the 1990s to these non-fundamental shocks.VAR; monetary policy; asset prices; identification

Discretion and the transmission lags of monetary policy

Monetary policy transmission lags create credibility problems for the inflation-targeting policy maker who acts under discretion. We show that if prices react to monetary policy with a longer lag than output, the welfare maximizing inflationtargeting policy implies no policy stabilization of cost-push shocks in the canonical New Keynesian model. The reason is simple: for the period monetary policy influences output, inflation is predetermined and the best discretionary policy is to stabilize the output gap fully. We find that money growth targeting comes close to replicating the welfare-maximizing policy under commitment if there are transmission lags.discretionary and stabilization bias; monetary policy; transmission lags; inflation targeting; money targeting

Inflation targeting strategies in small open economies

According to recent literature on monetary policy, there are two different interpretations of inflation targeting; (1) an instrument rule that responds to a measure of inflation (forecast) deviations from target and (2) a discretionary optimizing strategy towards minimizing the inflation deviations from its target. This paper compares these strategies with some simple rules for monetary policy. In particular, attention is given to the strategies’ impact on the traded and non-traded sectors of the economy. Our conclusions suggest that there are considerable advantages in committing to a specific interest rate rule instead of letting the central bank discretionarily decide on the inflation targeting policy. The paper also provides evidence that the Taylor rule may work reasonably well in an open economy setting and gives only partial support for the Ball (1998) critique. It also discusses the structural conditions for successful targeting of inflation

Methods for robust control

Robust control allows policymakers to formulate policies that guard against model misspecification. The principal tools used to solve robust control problems are state-space methods (see Hansen and Sargent 2006 and Giordani and Soderlind 2004). In this paper we show that the structural-form methods developed by Dennis (2006) to solve control problems with rational expectations can also be applied to robust control problems, with the advantage that they bypass the task, often onerous, of having to express the reference model in statespace form. Interestingly, because state-space forms and structural forms are not unique the two approaches do not necessarily return the same equilibria for robust control problems. We apply both state-space and structural solution methods to an empirical New Keynesian business cycle model and find that the differences between the methods are both qualitatively and quantitatively important. In particular, with the structural-form solution methods the specification errors generally involve changes to the conditional variances in addition to the conditional means of the shock processes.Robust control ; Monetary policy ; Econometric models

Monetary policy in a small open economy with a preference for robustness

We use robust control techniques to study the effects of model uncertainty on monetary policy in an estimated, semi-structural, small-open-economy model of the U.K. Compared to the closed economy, the presence of an exchange rate channel for monetary policy not only produces new trade-offs for monetary policy, but it also introduces an additional source of specification errors. We find that exchange rate shocks are an important contributor to volatility in the model, and that the exchange rate equation is particularly vulnerable to model misspecification, along with the equation for domestic inflation. However, when policy is set with discretion, the cost of insuring against model misspecification appears reasonably small.Monetary policy

Effects on the trade and non-traded sectors

The paper considers alternative monetary policy regimes within a calibrated macroeconomic model with a traded and a non-traded sector. Two classes of regimes are considered; inflation targeting and exchange rate targeting. When the target variable is completely stabilized, both rules have poor stabilizing properties for all real variables - nominal exchange rate targeting is even dynamically unstable. When the monetary authority places some weight on output stabilization in addition to the primary target variable, inflation targeting outperforms exchange rate targeting in terms of output stability in both the traded and the non-traded sectors