Targeting inflation by forecast feedback rules in small open economies

We argue that in practice, the inflation-targeting strategy can be approximated by the interest rate responding to the unchanged-interest-rate forecast of inflation. A method is developed to derive unchanged-interest-rate forecasts in forward-looking models and evaluate the performance of the policy rule in an optimizing New Keynesian model due to Monacelli (European Central Bank, Working Paper Series: 227), estimated on UK data. We find that the policy rule is less prone to generate a determinate rational expectations equilibrium if based on an unchanged interest rate, compared to the rule-consistent forecast. Both rules approximate the optimal commitment policy if the central bank attaches sufficient weight to inflation as opposed to output gap stabilization. The optimal forecast-feedback horizon is close to a year and a half and is largely independent of how much the central bank prefers inflation to output gap stability.