Central Banking, Monetary Theory and Practice

Central Banking, Monetary Theory and Practice

Essays in Honour of Charles Goodhart, Volume One

Edited by Paul Mizen

Celebrating the contribution that Charles Goodhart has made to monetary economics and policy, this unique compendium of original papers draws together a highly respected group of international academics, central bankers and financial market regulators covering a broad range of issues in modern monetary economics. Topics discussed include: central bank independence; credibility and transparency; the inflation forecast and the loss function; monetary policy experiences in the US and the UK; the implications of Goodhart’s Law; the benefits of single versus multiple currencies; and money, near monies and credit.

Chapter 4: The inflation forecast and the loss function

Lars E.O. Svensson

Subjects: economics and finance, money and banking


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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