FEDERAL RESERVE BANK OF SAN FRANCISCO WORKING PAPER SERIES Inflation Targeting under Imperfect Knowledge Athanasios Orphanides Board of Governors of the Federal Reserve System and John C. Williams Federal Reserve Bank of San Francisco April 2006 Working Paper 2006-14 http://www.frbsf.org/publications/economics/papers/2006/wp06-14bk.pdf The views in this paper are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Federal Reserve Bank of San Francisco or the Board of Governors of the Federal Reserve System. Inflation Targeting under Imperfect Knowledge∗ Athanasios Orphanides Board of Governors of the Federal Reserve System and John C. Williams Federal Reserve Bank of San Francisco April 2006 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 mon- etary 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. Keywords: Learning, Natural rate of interest, natural rate of unemployment, rational expectations, monetary policy rules, uncertainty, bond prices. JEL Classification: D83, D84, E52, E58. ∗We would like to thank Richard Dennis, Bill English, Ali Hakan Kara, Thomas Laubach, Nissan Liviatan, John Murray, Rodrigo Vergara, and participants of presentations at the Federal Reserve Board, the Bundesbank, the Federal Reserve Banks of Chicago and New York, the American Univer- sity, the conference on “Monetary Policy under Inflation Targeting,” Santiago, October 20–21, 2005, the conference in honor of Alex Cukierman on “New Developments in the Analysis of Monetary Policy and Institutions,” Tel Aviv, December 15–16, 2005, and the British Columbia Macro/Bank of Canada conference, Vancouver, April 7-8, 2006, 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. Correspondence: Orphanides: Federal Reserve Board, Washington, D.C. 20551, Tel.: (202) 452-2654, e-mail: [email protected]. Williams: Federal Reserve Bank of San Francisco, 101 Market Street, San Francisco, CA 94105, Tel.: (415) 974-2240, e-mail: [email protected]. 1 Introduction A central tenet of inflation targeting is that establishing and maintaining well-anchored inflation expectations are essential. Well-anchored expectations enables inflation-targeting central banks to achieve greater stability of output and employment in the short-run, while ensuring price stability in the long-run. Three elements of inflation targeting have been crit- ically 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 and 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 hori- zons. Together, these elements provide a focal point for inflation, facilitate the formation of the public’s inflation expectations, and provide guidance as to actions that may be needed to foster price stability. Although inflation-targeting (IT) central banks have stressed these key elements, the literature that has studied inflation targeting in the context of formal models has largely described 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 appreci- ation of the special features of the inflation-targeting framework, as emphasized by Faust and Henderson (2004), and strips from IT its raison d’ˆetre. 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 excep- tion 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 1A number of studies have examined in detail the defining characteristics of inflation targeting. See Leiderman and Svensson (1995), Bernanke and Mishkin (1997), Bernanke et al (1999), Goodfriend (2004), and citations therein. 1 bank or provide useful information to the policymaker for guiding policy decisions. In this paper, we argue that in order to understand the attraction of IT to central bankers and its effectiveness relative to other monetary policy strategies, it is essential to recognize economic agents’ imperfect understanding of the macroeconomic landscape within which the public forms expectations and policymakers must formulate and implement monetary policy. To this end, we consider two modest deviations from the perfect knowledge rational expectations benchmark, and reexamine the role of the key elements of the inflation targeting framework in the context of an economy with imperfect knowledge. We find that including these modifications provides a rich framework in which to analyze inflation targeting strategies and their implementation. The first relaxation of perfect knowledge that we incorporate is to recognize that policy- makers face uncertainty regarding the evolution of key natural rates. In the United States, for example, estimates of the natural rates of interest and unemployment are remarkably imprecise.2 Indeed, this problem is arguably even more dramatic for small open economies and transitional economies that have tended to adopt IT. As is well known, policymaker misperceptions regarding the evolution of natural rates can result in persistent policy errors, hindering successful stabilization policy.3 The second modification that we allow for is the presence of imperfections in expecta- tions formation that arise when economic agents have incomplete knowledge of the econ- omy’s structure. We assume that agents rely on an adaptive learning technology to update their beliefs and form expectations based on incoming data. Recent research has high- lighted the ways in which imperfect knowledge can act as a propagation mechanism for macroeconomic disturbances in terms of amplification and persistence that have first-order implications for monetary policy.4 Agents may rely on a learning technology to guard against numerous potential sources of uncertainty. One source could be the evolution of natural rates in the economy, paralleling the uncertainty faced by policymakers. But an- 2For discussion and documentation of this imprecision see Orphanides and Williams (2002), Laubach and Williams (2003), Clark and Kozicki (2005) and references therein. See also Orphanides and van Norden (2002) for the related unreliability regarding the measurement of the natural rate of output and implied output gap. 3For analyses of the implications of misperceptions for policy design see Orphanides and Williams (2002); Orphanides (2003a); Cukierman and Lippi (2005); and references therein. 4See Orphanides and Williams (2004, 2005a,b,c); Gaspar and Smets (2002); Gaspar, Smets and Vestin (2005); Milani 2005; and references in these papers. 2 other might be uncertainty regarding the policymaker’s understanding of the economy, and likely response to economic developments, and perhaps the precise quantification of policy objectives. Recognition of this latter element in the economy highlights a role for central bank communications, including that of an explicit quantitative inflation target, that would be absent in an environment of perfect knowledge. We investigate the role of inflation targeting in an environment of imperfect knowledge using an estimated quarterly model of the U.S. economy. Specifically, we compare the per- formance of the economy subject to shocks with characteristics similar to those observed in the data over the past four decades under alternative informational assumptions and policy strategies.