In 2008 all ECB publications feature a motif taken from the 10 banknote. This paper can be downloaded without charge from

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publications feature a motif taken from the 20 banknote. This paper can be downloaded without charge from

Inflation targeting has been widely adopted in both developed and emerging economies. In this essay, I survey the evidence on the effects of inflation targeting on macroeconomic performance and assess what lessons this evidence provides for inflation targeting and the design of monetary policy. While macroeconomic experiences among both inflation targeting and non-targeting developed economies have been similar, inflation targeting has improved macroeconomic performance among developing economies. Importantly, inflation targeting has not been associated with greater real economic instability among either developed or developing economics. While cost shocks, such as the large rise in commodity prices that occurred in 2007 and early 2008, force central banks to make difficult short-run trade-offs, the ability to deal with demand shocks and financial crises can be enhanced by a commitment to an explicit target. This article was adapted from the John Kuszczak Memorial Lecture, prepared for the conference on ‘International Experience with the Conduct of Monetary Policy under Inflation Targeting’, held at the Bank of Canada, 22–23 July 2008. I would like to thank Mahir Binici for excellent research assistance and conference participants and an anonymous referee for comments and suggestions. Views expressed and remaining errors are my own.

We distinguish between two kinds of FOMC forward guidance. Odyssean forward guidance changes private expectations by publicly committing the FOMC to future deviations from its underlying policy rule. Circumstances will tempt the FOMC to renege on these promises precisely because the policy rule describes its preferred behavior. All other forward guidance is Delphic in the sense that it merely forecasts the future. Prominent monetary policy proposals for providing more accommodation at the zero lower bound, such as the one elucidated by Eggertsson and Woodford (2003), rely on Odyssean forward guidance. Are these policies viable? We develop a new methodology based on a traditional interest rate policy rule that uses data on federal funds futures and market participant’s expectations of future economic conditions to measure Odyssean forward guidance. Our empirical evidence suggests that the public has experience with Odyssean forward guidance, so monetary policies that rely upon it may be viable. Armed with this evidence, we investigate the consequences of providing Odyssean forward guidance at this time.

effectiveness of quantitative forward guidance evidence from three inflation targeters

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We examine the effects of the release by a central bank of its expected future interest rate in a simple two-period model with heterogeneous information between the central bank and the private sector. The model is designed to rule out common-knowledge and time-inconsistency effects. Transparency—when the central bank publishes its interest rate path—fully aligns central bank and private-sector expec-tations about the future inflation rate. The private sector fully trusts the central bank to eliminate future inflation and sets the long-term interest rate accordingly, leaving only the unavoidable central bank forecast error as a source of inflation volatility. Under opacity—when the central bank does not pub-lish its interest rate forecast—current-period inflation differs from its target not just because of the unavoidable central bank expectation error but also because central bank and private-sector expectations about future inflation and interest rates are no longer aligned. Opacity may be creative and raise wel-fare if the private sector’s interpretation of the current interest rate leads it to form a view of expected inflation and to set the long-term rate in a way that systematically offsets the effect of the central bank forecast error on inflation volatility. Condi-tions that favor the case for transparency are a high degree of precision of central bank information relative to private-sector information, a high precision of early information, and a high elasticity of current to expected inflation.

By providing guidance about future economic developments, central banks can affect private sector expectations and decisions. This can improve welfare by reducing private sector forecast errors, but it can also magnify the impact of noise in central bank forecasts. I employ a model of heterogeneous information to compare outcomes under opaque and transparent monetary policies. While better central bank information is always welfare improving, more central bank information may not be. (JEL E52, E58) Federal Reserve Bank of St. Louis Review, July/August 2008, 90(4), pp. 421-42. Standard models used for monetary policy analysis typically assume that households and firms and the central bank share a common information set and economic model, yet actual policy decisions are taken in an environment in which heterogeneous information is the norm and many alternative models coexist. The resulting heterogeneity in

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