The Inflation Forecast and the Loss Function

This Paper argues that inflation-targeting central banks should announce explicit loss function with numerical relative weights on output-gap stabilization and use and announce optimal time-varying instrument-rate paths and corresponding inflation and output-gap forecasts. Simple voting procedures for forming the Monetary Policy Committee’s aggregate loss function and time-varying instrument-rate paths are suggested. Announcing an explicit loss function improves the transparency of inflation targeting and eliminates some misunderstandings of the meaning of ‘flexible’ inflation targeting. Using time-varying instrument-rate paths avoids a number of inconsistencies and other problems inherently associated with constant-interest-rate forecasts.