Irrational Expectations and Econometric Practice Discussion of Orphanides and Williams, 'Inflation Scares and Forecast-Based Monetary Policy'

Abstract

Abstract: Athanasios Orphanides and John C. Williams' excellent conference paper, Inflation Scares and Forecast-Based Monetary Policy, contributes importantly to the new and rapidly growing branch of the literature on bounded rationality and learning in macroeconomics. Their paper, like many others, derives interesting and useful theoretical results that show how the introduction of bounded rationality and learning impacts on the effects of monetary policy shocks and the characteristics of optimal monetary policy rules. This note suggests that some additional empirical work--some irrational expectations econometrics, if you will--might serve to make these purely theoretical results seem more relevant and convincing. Irrational Expectations and Econometric Practice Discussion of Orphanides and Williams, Inflation Scares And Forecast-Based Monetary Policy 1 Irrational Expectations ... Athanasios Orphanides and John C. Williams' excellent conference paper, Inflation Scares and Forecast-Based Monetary Policy, takes as one of its starting points the observation that many central banks around the world devote considerable resources towards producing their own, internal macroeconomic forecasts and towards monitoring private, external macroeconomic forecasts. And, moreover, monetary policy actions taken by central banks around the world often appear to be driven, at least in part, by changing internal and private macroeconomic forecasts. Within the Federal Reserve System, for example, the Greenbook--which presents the macroeconomic forecasts generated by the Federal Reserve Board sta.-serves as one of the principal documents guiding the policy deliberations at each meeting of the Federal Open Market Committee. Orphanides and Williams' paper takes its second starting point another observation: that most contemporary models of the monetary business cycle attach no special importance to macroeconomic forecasts in the design of monetary policy rules. To see where this result comes from, and why it holds true so generally, consider a very simple model in which, for some reason, the central bank decides to set its policy instrument, the short-term nominal interest rate [r.sub.t] at time t, as a linear function of expected or forecasted output [y.sup.e.sub.t+1] and inflation [[pi].sup.e.sub.t+1] at time t + 1, according to the policy rule [r.sub.t] = [[alpha].sub.y][y.sup.e.sub.t+1] + [[alpha].sub.[pi]][[pi].sup.e.sub.t+1], (1) where [[alpha].sub.y] and [[alpha].sub.[pi]] are coefficients chosen by the central bank that measure the sensitivity of the interest rate response to movements in expected output and inflation. Next, suppose that the structure of this simple model implies that the forecasts [y.sup.e.sub.t+1] and [[pi].sup.e.sub.t+1] of output and inflation at time t + 1 are optimally constructed as linear functions of the actual levels of output and inflation at time t, so that [y.sup.e.sub.t+1] = [[beta].sub.y][y.sub.t] + [[beta].sub.[pi]][[pi].sub.t] (2) and [[pi].sup.e.sub.t+1] = [[delta].sub.y][y.sub.t] + [[delta].sub.[pi]][[pi].sub.t], (3) where the reduced-form parameters [[beta].sub.y], [[beta].sub.[pi]], [[delta].sub.y], and [[delta].sub.[pi]] may depend in potentially complicated ways on the model's underlying structural parameters describing private agents' tastes and technologies as well as on the parameters of the monetary policy rule (1). Optimal forecasting rules take the linear form exhibited by (2) and (3) not just in this simple model but in any member of the broad class of linear or linearized rational expectations models that have been developed and used in the literature on monetary economics over the past quarter century. In more complicated models, additional lags of output and inflation as well as additional lags of other endogenous variables besides output and inflation may appear in the optimal forecasting rules. …