Are Constant Interest Rate Forecasts Modest Policy Interventions? Evidence from a Dynamic Open‐Economy Model

Malin Adolfson (), Stefan Laséen (), Jesper Lindé and Mattias Villani

International Finance, 2005, vol. 8, issue 3, 509-544

Abstract: This paper uses an estimated open‐economy dynamic stochastic general equilibrium model for the euro area to examine if during 1993Q4–2002Q4 constant interest rate forecasts (CIRFs), commonly used by inflation‐targeting central banks, are viewed as being in line with the central bank's historical policy behaviour. In the sense of Leeper and Zha (2003), a CIRF is defined as a modest intervention of the policy rule if it does not trigger the agents to revise their expectations about the inflation‐targeting policy. Using univariate modesty statistics, we show that the modesty of the policy interventions depends on the assumptions about the uncertainty in the future shock realizations. Taking the joint effects of the policy interventions on all variables into consideration, we find that the CIRFs are not modest policy interventions in the latter part of the sample (1998Q4–2002Q4), and thereby affect the expectations formation of the agents. Consequently, the constant interest rate assumption has arguably led to conditional forecasts at the two‐year horizon that cannot be considered economically meaningful during this period, and should not be used as a communication device by inflation‐targeting central banks.

Date: 2005
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