Inter-forecast Monetary Policy Implementation: Fixed-Instrument Versus MCI-Based Strategies

Abstract

Monetary policy authorities can adjust their policy instrument at any point in time to achieve their inflation objective. In some countries, such as the United States and the United Kingdom, policymakers generally make adjustments only after a formal medium-term inflation forecast. Other countries, like Canada and New Zealand, have used simple inter-forecast strategies to make further instrument adjustments in response to unexpected developments in the exchange rate. These alternative strategies may be thought of as fixing or banding a Monetary Conditions Index (MCI) that is comprised of the exchange rate and a short-term interest rate closely linked to the policy instrument. The work presented in this paper uses the Reserve Bank of New Zealand's macroeconomic model to examine the stabilisation properties of these alternative inter-forecast instrument-adjustment strategies. Generally, fixing or banding an MCI by adjusting the policy instrument between forecast in response to unexpected exchange rate developments does not appear to reduce the variability of inflation or output relative to holding the instrument fixed. However, in the special case where the only source of macroeconomic variability is unexpected shocks to the exchange rate, fixing an MCI does reduce inflation and output variability. In all but the special case, the MCI-based strategies lead to larger required adjustments in the policy instrument once the next inflation forecast is considered. Consequently, if policymakers are averse to large changes in the policy instrument, following an inter-forecast MCI-based strategy can increase inflation variability relative to the fixed-instrument strategy.