Tuesday, January 6, 2009

Best practice monetary policy?

Mostly Economics draws attention to a paper by Lars EO Svensson who describes the Norwegien Central Bank's policy of "managing the private sector's expectations about the future... through a 'forecast targeting' framework" as the best-practice monetary policy.

It is based on the premise that
1. the impact of monetary policy on inflation and output depends on the private-sector decisions about prices and output that it induces, and
2. what matters for the private sector investment decisions is not the current instrument rate at all, but their expectations about future interest rates.

And, this in turn is achieved by "announcing, discussing and motivating the bank’s forecasts of inflation, the output gap, and, importantly, the instrument rate". The Bank decides on an optimal instrument-rate plan that results in inflation and output-gap forecasts that are deemed to best achieve the bank’s objective.

Two issues here. One, I am not sure whether there is any difference between conventional "inflation tageting" (on a target band) and the "best-practice" "optimal instrument rate plan forecast". Second, taking cue from Dani Rodrik's scepticism about such "best-practices" approaches, it remains to be seen as to how effective will such strategies be in managing monetary policy during economic crises (the Svensson paper was written in 2006, with data drawn from the Norges Bank experience of the calmer times of the first half of the decade).

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