Relative Inflation-Forecast as Monetary Policy Target for Convergence to the Euro

Abstract:     
A monetary policy framework based on targeting a relative inflation-forecast is proposed for the economies converging to the euro. Such strategy aims at containing the differentials between the domestic and the implicit monetary union inflation-forecasts. Hence, these differentials become a basis for setting an operational policy target. The proposed framework can be viewed as an extension of flexible inflation targeting that prioritizes low and stable inflation over the exchange rate stability. It is believed to be consistent with the Maastricht convergence criteria and can be implemented in concurrence with the exchange rate stability benchmark for the ERM2. Several empirical tests are conducted to determine feasibility of adopting an instrument rule for the proposed policy framework in the three largest inflation-targeting candidates to the euro: the Czech Republic, Hungary and Poland. The stability tests as well as the volatility dynamics tests suggest that adoption of the relative inflation-forecast targeting framework is possible in these countries.

Keywords: Inflation Targeting, Exchange Rate, Monetary Convergence, ERM2, New EU Member States, GARCH

JEL Classification: E42, E52, F36, P24

Accepted Paper Series