Distribution forecast targeting in an open-economy, macroeconomic volatility and financial implications

• Open-economy with parameter uncertainty to study two inflation targeting policies.
• Parameter uncertainty introduced with Markov jump-linear-quadratic systems.
• Targeting core inflation leads to less volatility than targeting headline inflation.
• Interest rate volatility minimized by targeting core inflation.
• Empirical positive relationship between interest rate volatility and financial instability.

In an open-economy faced with parameter uncertainty, this paper uses distribution forecasts to investigate the impact of alternative inflation targeting policies on macroeconomic volatility and their potential implications on financial stability. Theoretically, Domestic Inflation Targeting (DIT) leads to less volatility than Consumer Price Index Inflation Targeting (CPIIT) for several macroeconomic variables and, in particular, for the interest rate. Empirically, a positive relationship between interest rate volatility and financial instability emerges for the US, UK and Sweden since the early 1990s. Bridging theory and empirical evidence, we conclude that the choice of the inflation targeting regime has an important impact on macroeconomic volatility and potential implications for financial stability.