Scott Sumner  

Target the unbiased forecast

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Lars Svensson has argued that central banks should "target the forecast", which means setting the policy instruments at a position where the policy goal is equal to the policy forecast. He specifically referred to targeting the central bank's own internal forecast.

In contrast, I've argued that central banks should target the market forecast, that is, set policy at a position where the market expects success. The recent experience of the Bank of Japan provides a good illustration as to why it's better to target the market forecast:

Japan's headline inflation slowed in March from February, highlighting the central bank's struggle to hit its 2 percent price growth target after five years of heavy stimulus, keeping it under pressure to maintain an ultra-easy monetary policy. . . .

"We expect inflation excluding fresh food to average 1 percent in the current fiscal year, below the median forecast among BOJ board members of 1.4 percent," said Marcel Thieliant, senior Japan economist at Capital Economics.

"If we are right, the bank will have to reduce its inflation forecasts yet again over the coming months, underlining that policy tightening is a long way off."

Sources familiar with the central bank's thinking said it is likely to maintain the view that inflation will reach its 2 percent target next fiscal year, and will stay near that level the following year, when it issues new forecasts next week.

Those projections could increase the prospects of the BOJ deciding to debate whittling down its massive stimulus next fiscal year.


The Bank of Japan is under a lot of pressure to forecast an outcome that is relatively close to their target, especially for one or two years in the future (when policy is able to affect inflation.) The reason is simple; inflation targeting is the BOJ's primary job, and it looks bad if they were to continually forecast failure.

But this is precisely why I disagree with Svensson's approach to targeting the forecast. Because of these political pressures, we cannot rely on the BOJ to provide honest, unbiased forecasts of inflation. Almost all other forecasters predict that the BOJ will continue to undershoot its 2% inflation target for the foreseeable future. The BOJ has consistently been overly optimistic in its inflation forecast (much more so than the Fed), and I believe the current forecast will also prove to be too optimistic. Policy should be steered by market participants that are under no pressure to produce happy face forecasts.

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COMMENTS (6 to date)
bill writes:

Dead on.

Todd Kreider writes:

This 2% inflation targeting is mysticism. Of course you don't want serious defation but since 2000, Japan, at around 0% inflation has grown, GDP per capita, at almost the same rate as the U.S., which has had an average of 2% (somewhere around there).

Real GDP per capita growth is what matters.

Rajat writes:

The RBA has 'solved' the BoJ's conundrum by inserting a vague 'financial stability' limb into its mandate. This way, the RBA is able to forecast below-target inflation for years at a time (thereby avoiding the embarrassment the BoJ would experience from forecasting accurately) without looking like they've failed.

The RBA Governor, Philip Lowe, has even gone as far as perverting the historical usage of the term by saying, "We have not been what some have called ‘inflation nutters’", as to mean, 'We're not so obsessed with hitting our inflation target that we will try to bring inflation back to target quickly, in a way that could lead to excess leverage and debt' - I'm not making this up: https://www.businessinsider.com.au/philip-lowe-says-the-rba-isnt-full-of-inflation-nutters-2016-9

Scott Sumner writes:

Thanks Bill.

Todd, You are right that 2% inflation won't do much for growth, but it will do several other things:

1. Improve the efficiency of monetary policy.

2. Reduce the ratio of public debt to GDP.

This is why it's important that the BOJ hit its inflation target.

BTW, Japan is much poorer than the US, and hence ought to be growing faster. But that requires supply-side reforms.

Rajat, Perhaps someday they will learn that low inflation doesn't do anything to prevent "bubbles".

Todd Kreider writes:

Scott,

I thought of your points before posting.

1. Improving the efficiency of monatary efficiency doesn't seem to have been necessary to have the same growth rate as the U.S., U.K or France for the past 18 years.

2. The ratio of net debt to GDP, which is what might matter: 40%, 90% (Weinstein at Columbia) or 120%, depending on how one calculates, hasn't increased since 2012 and that as well hasn't kept Japan from growing at the same rate as the U.S., U.K. or France.

3. As for Japan being "much poorer than the U.S., and hence should be growing faster," as you wrote, this is basically true but there are caveats including that all large OECD countries are poorer than the U.S.:

GDP per capita (PPP):

U.S. $60,000
Germany $50,000
France $44,000
Japan $43,000

The French and Germans also work 20% fewer hours than Americans and the British work 10% fewer hours while Japanese work 5% fewer hours.

If looking at median standard of living, inequality skews the GDP per capita upward in the U.S. so that the typical Japanese is not 18% poorer than the typical American but closer to 10% poorer so on a a typical individual basis, not "much poorer."

Todd Kreider writes:

Sorry for the typos!

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