Average inflation targeting can be destabilizing
Honkapohja and McClung in this paper consider the question of whether average inflation targeting (AIT) can stabilize average inflation and anchor long-run expectations when key details of the policy regime are not public knowledge. The authors use a New Keynesian model with adaptive learning agents to analyze the performance of AIT to provide a detailed analysis of the potential de-anchoring risks associated with AIT. Honkapohja and McClung argue that:
The instability problem reflects a tension between stabilizing a finite moving average of inflation and stabilizing long-run inflation expectations which are influenced by data. Following a period of low inflation, the central bank aims for a period of high inflation. If agents underestimate the averaging window, they will confuse some part of the transitory rise in inflation for higher permanent inflation and raise long-run expectations accordingly. This de-anchoring of expectations from the target exacerbates the inflation overshooting of the target relative to the case of rational agents.
To mitigate this effect, the authors suggest either:
- The adoption of an asymmetric policy that aims for overshooting of the inflation target but not undershooting of the target, can stabilize expectations under learning with opacity about the policy rule and averaging window.
- The communication of the averaging window length i.e. the number of lags in the policy rule. If agents incorporate this information about the history-dependence of policy into learning, then the target steady state is fairly robustly stable, and AIT can even succeed in guiding the economy out of a liquidity trap.
On Robustness of Average Inflation Targeting
Authors: Seppo Honkapohja, Nigel McClung
From: Aalto University School of Business, Bank of Finland
Average inflation targeting is more robust than inflation targeting
In this paper, de Fiore et al. discuss the performance of average inflation targeting compared to aggressive inflation targeting during the recent inflation surge. The authors use a medium-scale DSGE model to evaluate the role of different monetary policy rules in influencing the inflation path during 2019Q4-2023Q3. The analysis includes the estimation and simulations using the New York Fed model, and it considers alternative possible monetary policies of the Federal Reserve, such as an “aggressive” inflation targeting rule and an accommodative policy that provides forward guidance on future policy rates. They find:
We illustrate that the benefits of a dual mandate relative to a single mandate increase when the Phillips curve is flatter; that AIT rules tend to stabilize inflation and interest rates relative to IT rules but at the cost of higher output volatility; and that AIT is more robust than IT to a possible misperception of r∗.
Monetary policy frameworks away from the ELB
Authors: Fiorella De Fiore, Benoît Mojon, Daniel Rees, Damiano Sandri
From: BIS
