Banco Central de Chile Documentos de Trabajo Central Bank of Chile Working Papers N° 398 Diciembre 2006 INFLATION TARGETING UNDER IMPERFECT KNOWLEDGE Athanasios Orphanides John C. Williams La serie de Documentos de Trabajo en versión PDF puede obtenerse gratis en la dirección electrónica: http://www.bcentral.cl/esp/estpub/estudios/dtbc. Existe la posibilidad de solicitar una copia impresa con un costo de $500 si es dentro de Chile y US$12 si es para fuera de Chile. Las solicitudes se pueden hacer por fax: (56-2) 6702231 o a través de correo electrónico: [email protected]. Working Papers in PDF format can be downloaded free of charge from: http://www.bcentral.cl/eng/stdpub/studies/workingpaper. Printed versions can be ordered individually for US$12 per copy (for orders inside Chile the charge is Ch$500.) Orders can be placed by fax: (56-2) 6702231 or e-mail: [email protected]. 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Documentos de Trabajo del Banco Central de Chile Working Papers of the Central Bank of Chile Agustinas 1180 Teléfono: (56-2) 6702475; Fax: (56-2) 6702231 Documento de Trabajo Working Paper N° 398 N° 398 INFLATION TARGETING UNDER IMPERFECT KNOWLEDGE Athanasios Orphanides John C. Williams Board of Governors of the Federal Reserve Bank of San Francisco Federal Reserve System Resumen Un principio central del esquema de metas de inflación es la importancia que se da a establecer y mantener bien ancladas las expectativas inflacionarias. En este artículo revisamos el papel que juegan ciertos elementos claves de dicho esquema para cumplir con este objetivo, en una economía en la que los agentes económicos tienen una comprensión imperfecta del ámbito económico dentro del cual el público construye sus expectativas y la autoridad debe formular e implementar la política monetaria. Usando un modelo estimado de la economía de Estados Unidos, mostramos que ciertas reglas de política monetaria que funcionarían bien bajo el supuesto de expectativas racionales, pierden gran parte de su eficacia cuando se introduce el conocimiento imperfecto. Luego examinamos el desempeño de una regla de política de fácil aplicación que incorpora tres características esenciales del esquema de metas de inflación: transparencia, compromiso de mantener la estabilidad de precios y un monitoreo estricto de las expectativas de inflación, y encontramos que los tres juegan un rol importante para asegurar su éxito. Nuestro análisis sugiere que las reglas de diferencia simple en el espíritu de Knut Wicksell son excelentes para anclar las expectativas inflacionarias a la meta del banco central, y que al hacerlo logran una mejor estabilización de la inflación y de la actividad económica en un ambiente de conocimiento imperfecto. Abstract A central tenet of inflation targeting is that establishing and maintaining well-anchored inflation expectations are essential. In this paper, we reexamine the role of key elements of the inflation targeting framework towards this end, in the context of an economy where economic agents have an imperfect understanding of the macroeconomic landscape within which the public forms expectations and policymakers must formulate and implement monetary policy. Using an estimated model of the U.S. economy, we show that monetary policy rules that would perform well under the assumption of rational expectations can perform very poorly when we introduce imperfect knowledge. We then examine the performance of an easily implemented policy rule that incorporates three key characteristics of inflation targeting: transparency, commitment to maintaining price stability, and close monitoring of inflation expectations, and find that all three play an important role in assuring its success. Our analysis suggests that simple difference rules in the spirit of Knut Wicksell excel at tethering inflation expectations to the central bank’s goal and in so doing achieve superior stabilization of inflation and economic activity in an environment of imperfect knowledge. _______________ Paper presented for the Ninth Annual Conference, Banco Central de Chile, October 2005. We would like to thank Richard Dennis, Bill English, Ali Hakan Kara, Thomas Laubach, Nissan Liviatan, John Murray, and Rodrigo Vergara for useful comments. The opinions expressed are those of the authors and do not necessarily reflect the views of the Board of Governors of the Federal Reserve System or the management of the Federal Reserve Bank of San Francisco. E-mails: [email protected]; [email protected] INFLATION TARGETING UNDER IMPERFECT KNOWLEDGE Athanasios Orphanides Board of Governors of the Federal Reserve System John C. Williams Federal Reserve Bank of San Francisco A central tenet of inflation targeting is that establishing and maintaining well-anchored inflation expectations are essential. Well-anchored expectations enable inflation-targeting central banks to achieve stable output and employment in the short-run, while ensuring price stability in the long-run. Three elements of inflation targeting have been critically important for the successful implementation of this framework.1 First and foremost is the announcement of an explicit quantitative inflation target and the acknowledgment that low, stable inflation is the primary objective and responsibility of the central bank. Second is the clear communication of the central bank’s policy strategy and the rationale for its decisions, which enhances the predictability of the central bank’s actions and its accountability to the public. Third is a forward-looking policy orientation, characterized by the vigilant monitoring of inflation expectations at both short-term and longer-term horizons. Together, these elements provide a focal point for inflation, facilitate the formation of the public’s inflation expectations, and provide guidance on actions that may be needed to foster price stability. We would like to thank Richard Dennis, Bill English, Ali Hakan Kara, Thomas Laubach, Nissan Liviatan, John Murray, and Rodrigo Vergara for useful comments. The opinions expressed are those of the authors and do not necessarily reflect the views of the Board of Governors of the Federal Reserve System or the management of the Federal Reserve Bank of San Francisco. 1. A number of studies have examined in detail the defining characteristics of inflation targeting. See Leiderman and Svensson (1995); Bernanke and Mishkin (1997); Bernanke and others (1999); Goodfriend (2004). Monetary Policy under Inflation Targeting, edited by Frederic Mishkin and Klaus Schmidt-Hebbel, Santiago, Chile. © 2007 Central Bank of Chile. 1 2 Athanasios Orphanides and John C. Williams Inflation Targeting under Imperfect Knowledge 3 Although inflation-targeting central banks stress these key elements, the literature that studies inflation targeting in the context of formal models largely describes inflation targeting in terms of the solution to an optimization problem within the confines of a linear rational expectations model. This approach is limited in its appreciation of the special features of the inflation-targeting framework, as emphasized by Faust and Henderson (2004), and it strips inflation targeting of its raison d’être. In an environment of rational expectations with perfect knowledge, for instance, inflation expectations are anchored as long as policy satisfies a minimum test of stability. Furthermore, with the possible exception of a one-time statement of the central bank’s objectives, central bank communication loses any independent role because the public already knows all it needs in order to form expectations relevant for its decisions. In such an environment, the public’s expectations of inflation and other variables are characterized by a linear combination of lags of observed macroeconomic variables, and, as such, they do not merit special monitoring by the central bank or provide useful information to the policymaker for