Challenges for Monetary Policy 1

Good monetary policy is both simple and complicated. The principles for good monetary policy are simple: Perform flexible inflation targeting, which means aiming to stabilize inflation around an explicit low positive numerical inflation target with some weight also on stabilizing the output gap, that is, stabilizing output around a measure of potential output. Because of the lags between monetary-policy actions and the effect on inflation and output, the way to do this is to look forward and perform forecast targeting, that is, to set the central bank’s instrument rate such that the inflation and the output-gap forecasts “look good, ” which means that the inflation and output-gap forecasts approach the inflation target and zero, respectively, some 1—3 years ahead. The practice of constructing these forecasts and deciding on the appropriate instrument rate (or rather, instrument-rate plan) is quite complicated, though, and requires the collection and processing of vast amounts of data, thorough analysis, and skillful combination of judgment and model results. Since monetary policy works via the expectations of future instrumentrate settings rather than the current instrument rate, and since expectations of future inflation and output matter for the private sector’s current pricing and production decisions, monetary policy is to a large extent the management of expectations. Therefore, the transparency an