VELOCITY FUTURES MARKETS: DOES THE FED NEED A STRUCTURAL MODEL?

I. INTRODUCTION During the 1990s, the concept of inflation targeting caught on among both monetary theorists and monetary policy makers. This interest took several forms. Some advocated a backward-looking approach (as exemplified by the Taylor rule), which would require central bankers to offset shocks that had driven inflation away from its target path. Others advocated a forward-looking approach whereby the central bank would target the forecast, that is, set policy in such a way that the optimal forecast of inflation was exactly equal to its target value. This forward-looking strategy could use either central bank or private forecasts of inflation. Some of those who advocated a forward-looking strategy based on private forecasts went so far as to suggest that such a policy would eliminate any need for the central bank to develop a structural model of the economy. Bernanke and Woodford (1997) criticized this line of analysis by suggesting that due to problems related to circularity and indeterminacy (or solution multiplicity (1)), a policy of targeting the forecast was not likely to be effective. In this article we argue that because the circularity problem can be easily remedied, a private forecast-based policy is feasible and central banks do not need a structural model of the economy. II. THE CIRCULARITY PROBLEM Because monetary policy impacts the price level with a "long and variable lag," it is not surprising that many economists have looked for ways of incorporating private-sector forecasts into the monetary policy making process. Taken to its logical extreme, such an approach would require the central bank to adjust its policy instrument until the private sector's forecast of inflation, for instance, was equal to the target value. At first glance, the idea of replacing a bureaucratic decision-making process with a simple rule based on rational expectations and efficient markets theory has great intuitive appeal. Bernanke and Woodford, however, showed that there is a circularity problem associated with attempts to target private-sector forecasts of inflation (or any other goal variable). If a policy of targeting the forecast were credible and effective, then at each and every point in time the market would expect the future price level to be equal to its target value. But in that case private-sector forecasts would be uninformative, that is, they would be unable to provide the monetary authority with information about economic shocks that might impact the price level, and thus would provide no guidance as to how the monetary authority could use its tools to offset those shocks. On closer inspection, it turns out that there are a number of distinct issues entangled in the general circularity problem. For instance, does the problem apply only to private-sector forecasts or to central bank forecasts as well? And are there ways of developing private-sector forecast-based policy rules that are not susceptible to the circularity problem? If the answer is yes, what does this imply about the widely held view that monetary authorities need to base policy on their own internal, structural models of the economy? Svensson (1997) suggested that his inflation forecast targeting proposal was not susceptible to the circularity problem because it relied on internal central bank forecasts, not private-sector forecasts. Bernanke and Woodford, however, showed that the effectiveness of Svensson's proposal was based on the fact that central bank forecasts were derived from a structural model of the economy and that the distinction between internal and external forecasts was essentially meaningless for the circularity problem. If the problem is not private-sector forecasts per se, then the next question is whether it is possible to set up a policy targeting rule based on private-sector forecasts that avoids the circularity problem and also minimizes the need for the central bank to rely on a structural model of the economy. …