Targeting Inflation by Forecast Feedback Rules in Small Open Economies

We argue that inflation-targeting strategy in practice can be approximated with the interest rate responding to the unchanged-interest-rate forecast of inflation. We develop a method to derive unchanged-interest-rate forecasts in forward-looking models and evaluate the performance of the policy rule in an optimizing New Keynesian model due to Monacelli (2003) estimated on UK data. We find that the policy rule is less prone to generate a determinate rational expectations equilibrium if based on an unchanged interest rate compared to the rule-consistent forecast. The rule approximates the optimal commitment policy if the central bank attaches sufficient weight to inflation as opposed to output gap stabilization. The optimal forecast horizon is robustly close to one and a half year