Average Inflation Targeting and Interest-Rate Smoothing

Abstract

We study the welfare implication of average inflation targeting as a simple interest-rate rule, in which the monetary authority adjusts its short-term policy rate in response to the output gap as well as average inflation deviation from its target instead of reacting to the contemporaneous inflation rate as in a Taylor-type rule. We find that the welfare improvement achieved by switching to average inflation targeting from a standard Taylor rule is modest with a high degree of interest-rate smoothing, whereas it is significant without interest-rate smoothing. We show that average inflation targeting is welfare-improving in the same way as interest-rate smoothing by making the conduct of monetary policy history-dependent. Thus, the high degree of monetary policy inertia in the estimated interest-rate rules in many advanced economies implies that the welfare gain from adopting the average inflation targeting rule would be modest.