Is Inflation Targeting Best-Practice Monetary Policy?

42 Pages Posted: 28 Jun 2004

See all articles by Jon Faust

Jon Faust

Board of Governors of the Federal Reserve - Division of International Finance; Johns Hopkins University

Dale W. Henderson

Federal Reserve Board

Date Written: May 2004

Abstract

We describe the inflation targeting framework (ITF) and compare it against hypothetical best-practice based on optimization. The core requirements of the ITF are an explicit long-run inflation goal and a commitment to transparency in policymaking. Advocates and practitioners of the ITF have made many contributions to clear goal setting and communication by central banks. However, we contend that ITF communication policies both as advocated and practiced often have some elements that either obfuscate or, in some cases, explicitly contradict the dictates of optimization in a stabilization-policy paradigm. In this paradigm, the central bank has an objective function that places weight on both inflation and output-gap stabilization and faces a conventional (exploitable) Phillips-curve trade-off. We point out some problems that the ITF communication policy may generate in this setting. Our analysis leads us to make four suggestions for communication policy intended to help central banks avoid these problems.

Keywords: Rules, discretion, commitment, transparency, communication, forecast, political economy, inflation bias, stabilization bias, trade off, expectations, fixed horizon, optimal policy, simple rule

JEL Classification: E50, E52, E58

Suggested Citation

Faust, Jon and Henderson, Dale W., Is Inflation Targeting Best-Practice Monetary Policy? (May 2004). Available at SSRN: https://ssrn.com/abstract=558685 or http://dx.doi.org/10.2139/ssrn.558685

Jon Faust

Board of Governors of the Federal Reserve - Division of International Finance ( email )

20th St. and Constitution Ave.
Washington, DC 20551
United States
202-452-2328 (Phone)
202-736-5638 (Fax)

Johns Hopkins University

Baltimore, MD 20036-1984
United States

Dale W. Henderson (Contact Author)

Federal Reserve Board ( email )

20th St. and Constitution Ave.
Washington, DC 20551
United States
202-452-2343 (Phone)
202-736-5638 (Fax)

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