What is the best practice monetary policy?

I didn’t know something like this existed. Anyways, Lars Svensson in this paper says it started with Norway Central Bank and is now followed by Sweden and NZ as well.

What is it but?

The impact of monetary policy on inflation and output depends on the private-sector decisions about prices and output that it induces. These decisions depend on the expectations about future inflation, output, and interest rates that monetary policy induces.

The current instrument rate matters hardly at all; what matters for private-sector decisions are the private sector’s expectations about future interest rates. Therefore, the implementation of best-practice monetary policy consists of announcing and motivating the bank’s forecasts of inflation, the output gap, and, importantly, the instrument rate.This is the most effective way of managing private-sector expectations.

(emphasis is mine)

In nut shell- central banks usually publish their forecasts of inflation and growth. What makes it best practice is forecasts of their own interest rates as well.

Four alternatives have been discussed for the instrument-rate path: (1) A constant instrument rate, (2) market expectations of future interest rates, (3) an instrument rate following an instrument rule, such as the Taylor rule, (4) an optimal instrument-rate path, that is, the path the central bank believes best achieves the bank’s objectives, which will also be the central bank’s own best forecast of future instrument rates.

I am convinced that best-practice monetary policy involves alternative (4), the optimal instrument rate forecast, that is, the central bank’s best forecast of its own future policy. By definition, this is the path the central bank deems to be optimal. Furthermore, since it is the best forecast of future interest rates, it provides the best information for private-sector decisions. Therefore, this is the most effective implementation of monetary policy, that is, the most effective way to manage private sector expectations. Finally, it provides the most accountability for the central bank. Since the resulting inflation and output-gap forecast rely on the central bank’s best instrument-rate forecasts, they are the central bank’s best inflation and output-gap forecast. Therefore, these  forecasts are the most relevant ones to compare with other forecasters’ forecasts and with the actual outcomes.

3 Responses to “What is the best practice monetary policy?”

  1. Interest Rates » What is the best practice monetary policy? « Mostly Economics Says:

    […] Read the rest of this great post here […]

  2. gulzar Says:

    If “managing private sector’s expectations about future interest rates” is the operative phrase, then I am reminded about an article by Paul Krugman (which I am not able to immediately locate) where he argues that in order to maximize their impact (on expectations) Central Banks should indulge in fewer, large enough and quick interest rate decisions, than small and meandering changes. Though, I am not sure whether this is applicable to extraordinary times like the one we are facing now.

    However, despite the extraordinary circumstances, I am inclined to believe that the RBI’s prevarication in cutting rates may have attenuated the impact (on expectaitons) of its belated cuts.

  3. Inflation targeting framework completes 20 years! « Mostly Economics Says:

    […] Bank (started best practice monetary policy) hosted a conferenceto review ITF’s 20 years. It has some great papers which tell you about […]

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