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From: Brookings Papers on Economic Activity
Fall 2011
pp. 333-352 | 10.1353/eca.2011.0022

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Comment by Randall S. Kroszner

This paper by Lars Svensson raises a fundamental question in monetary policy: would you rather be lucky, or would you rather be right? In his extremely valuable and comprehensive comparison of monetary policy decisions and outcomes in Sweden and the United States during 2010-11, Svensson argues, "The Riksbank did the wrong thing [by tightening policy] but was lucky, whereas the Federal Reserve did the right thing [by easing policy] but was unlucky."

Of course, you would prefer to be both right and lucky. Whether you would rather be right or lucky depends, perhaps, on whether you are an academic or a policymaker. If you are an academic, you always want to be right. You couldn't care less about luck. If you are a policymaker, however, it is difficult to ignore actual outcomes when, for example, you testify before Congress. You can explain that a policy choice was right based on information available ex ante. If the unemployment rate zooms up a year later through bad luck, however, you may have a difficult time convincing members of Congress and the public of the wisdom of that policy choice, regardless of the support you may have in the academic community. I certainly wish the United States had had a bit more "luck of the Swedish" when I was at the Federal Reserve in 2006-09.

I cannot do justice here to all of the important issues and arguments, ex post and ex ante, that Svensson covers in his careful and detailed comparison. I very much concur that, despite the differences in the statutory language that sets out the dual mandate of the Federal Reserve and the flexible inflation targeting of the Riksbank, in practice they both operate as "forecast targeting" regimes. Svensson defines forecast targeting as "setting the policy rate and choosing a policy rate path (and managing the central bank's balance sheet) so as to best stabilize the forecast of inflation around the inflation objective and the forecast of resource utilization around a sustainable level" (see also Kohn forthcoming, Woodford 2007). The Riksbank has a statutory mandate to keep annual inflation around 2 percent. The Federal Reserve, as revealed in the range of "long run" forecasts by individual Federal Open Market Committee (FOMC) members, for some years effectively targeted inflation at around 2 percent and recently announced an explicit inflation goal of 2 percent.

This focus on the forecasts strikes me not only as an accurate characterization of monetary policy practice in United States and Sweden but also as exactly right. Central bankers should try to make policy looking through the windshield rather than the rearview mirror. Getting the forecast right, of course, is a great challenge, and has been particularly so during the last few years of tremendous economic and market turbulence.

Going hand in hand with the focus on forecasts is a focus on expectations, since the forecasts and the impact of monetary policy will depend heavily upon the expectations of market participants. As Svensson emphasizes, "What is possible depends . . . on restrictions such as the zero lower bound (ZLB) on interest rates, the ability to manage expectations of future policy rates and inflation, and the availability of unconventional policy tools such as the size and composition of the central bank's balance sheet" (emphasis added).

I will focus here on the relationship between expectations management and communication strategy in monetary policy. I do so for three reasons. First, I believe expectations management is a tremendously important part of practical monetary policy (see, for example, Friedman 1968). Second, although I almost completely agree with Svensson's analysis of both U.S. and Swedish monetary policy during this period, I draw a different conclusion from his cross-country comparison about the impact of central bank communication on credibility and expectations management. Finally, as I believe the paper illustrates, how central bank communication affects expectations formation in practice is much less well understood than theory would suggest (I sometimes joke that we have a "faith-based" monetary policy in this respect), and thus we need significantly more empirical research to assess the effectiveness of different forms of central bank communication and transparency on expectations...

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