Requiem for Forecast-Based Instrument Rules

Abstract

Frequently used so-called forecast-based instrument rules are shown to correspond to a problematic intertemporal loss function. This loss function is problematic because it is timeinconsistent, arbitrary, and (for the most common form of forecast-based instrument rules) does not incorporate any explicit concern for output-gap stability. The time-inconsistency of the loss function arises because it does not have exponential discounting. This implies that in#ation paths that are optimal ex ante will not be realized ex post. This is a source of ineciency separate from the one discussed in the literature initiated by Kydland and Prescott and by Barro and Gordon. It follows that forecast-based instrument rules are not consistent with a conventional intertemporal loss function corresponding to #exible in#ation targeting. Keywords: Monetary policy rules, in#ation targeting JEL Classi...cation: E52, E58 I thank Annika Andreasson for editorial and secretarial assistance. Remaining errors and expressed views are my own. 1

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