Essays in Honour of Charles Goodhart, Volume One
Edited by Paul Mizen
Chapter 4: The inflation forecast and the loss function
4. The inﬂation forecast and the loss function Lars E.O. Svensson* 1. INTRODUCTION In Goodhart (2001), Charles defends the current use by the Bank of England’s Monetary Policy Committee (MPC) of inﬂation forecasts conditional on a constant interest rate. He also expresses misgivings about the appropriateness and feasibility of the MPC specifying an explicit loss function for monetary policy. This chapter criticizes Charles’s views and argues the opposite: that the MPC can and should specify an explicit loss function, and that it should abandon the constant-interest-rate forecasts for those conditional on time-varying interest-rate paths. Announcing an explicit loss function improves the transparency of inﬂation targeting and eliminates some common misunderstandings of the meaning of ‘ﬂexible’ inﬂation targeting. Using time-varying instrumentrate paths avoids a number of inconsistencies and other problems inherently associated with constant-interest-rate forecasts. Since I end up criticizing some of Charles’s views, I am afraid that this chapter may to some readers not correctly convey how deeply I admire Charles as a scholar, policy-maker and person, and how much I appreciate the opportunity (over many years in the past and hopefully many years in the future) to learn from his deep knowledge and vast experience, both by reading his work and by many discussions with him. Although I do not always agree with Charles, I always learn from him. Section 2 deals with specifying the loss function. Section 3 deals with forecasts conditional on constant or time-varying interest rate paths. Section 4 presents some conclusions...
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