The Dynamic Properties of Inflation Targeting Under Uncertainty

We study the implications of uncertainty for inflation targeting in a dynamic set-up. Using Svensson's inflation forecast targeting model, we compare the Brainard conservative principle to a more active monetary policy rule, derived from a two-step optimisation procedure. Our analysis points to a trade-o¤ between the ability to control expectations and the introduction of greater variability in the system. We show that Brainard's attenuation principle is optimal only in a backward looking set-up where there is no role for expectations in the determination of inflation equilibrium. On the other hand, we show that in a forward looking model, Brainard's conservative principle may produce instability, because of its inability to control expectations. A more aggressive rule, like the one derived in the paper, can instead provide greater stability because it providesfor a better and more direct management of expectations, despite the uncertainty in the transmission parameters. In that respect, we show that there are conditions under which the bene…ts of tying down expectations, more than compensate the costs of having to overuse the instrument.