Inflation Target Transparency and the Macroeconomy

We quantify the effects of monetary policy transparency and credibility on macroeconomic volatility in an estimated model of the euro area economy. In our model, private agents are unable to distinguish between temporary shocks to the central bank’s monetary policy rule and persistent shifts in the inflation target, and therefore use optimal filtering techniques to construct estimates of the future monetary policy stance. We find that the macroeconomic benefits of credibly announcing the current level of the time-varying inflation target are reasonably small as long as private agents correctly understand the stochastic processes governing the inflation target and the temporary policy shock. If, on the other hand, private agents overestimate the volatility of the inflation target, the overall gains of announcing the target can be substantial. We also show that the central bank to some extent can help private agents in their learning process by responding more aggressively to deviations of inflation from the target.