Inflation targeting under potential output uncertainty

Abstract

Monetary authorities in many industrialised countries have some form of price stability as their central objective. Because of the significant lags between policy actions and their subsequent impact on prices, policymakers must rely on indicators of future price pressure to guide current policy actions. One indicator that is often used is the difference between the current level of activity and potential output. Potential output, however, is unobservable and must be estimated from observable data.The only common feature that all of the techniques for estimating potential output share is uncertainty about their accuracy. Because of this uncertainty, policymakers are often criticised for relying on these estimates to guide their actions. In this paper, the degree of uncertainty surrounding estimates of New Zealand's potential output is used to consider whether potential output is in fact useful for guiding monetary policy. The analysis also traces out how the characteristics of efficient simple policy rules change as the magnitude and nature of the potential output uncertainty changes. In addition, the analysis also illustrates which of the simple policy rules considered are robust to potential output uncertainty.