Inflation targeting, or following Svensson “inflation forecast targeting,” has placed the forecasting process at the heart of monetary policy decision-making. Under inflation targeting, the forecasting process centres around future price developments. This does not necessarily mean, though, that central bankers are obsessed with inflation. In fact, inflation targeting requires assessing all the available information, including real economic developments, monetary analysis and external balance of the economy, in a systematic and complex way. It is hence more demanding from this point of view than the alternative monetary strategies. The inflation forecast is not only an important internal decision-making tool, but also a crucial communication device. Monetary policy has become considerably more transparent over recent decades. It is now commonly believed that open communication of monetary policy is beneficial to the stability and predictability of its transmission into the economy, and is also crucial for the accountability of an independent central bank. As a result, the inflation forecast, including its underlying assumptions and policy implications, is openly explained to the public. Nonetheless, we must always bear in mind that even highly developed, technically advanced and wellorganised forecasting procedures are not an automatic pilot for inflation-targeting central banks. They are no more - but also no less - than an important input into the monetary policy process. Eventually,  BIS Review 11/2004  1  the decision is always based not only on the central forecast itself, but also on the decision-makers’ discussions about all the associated risks.

The terms “Lucas critique” and “Goodhart law” have become standard warning signs for all macroeconomic modellers. As a result, the profession has started to prefer smaller-scale models with a sounder microeconomic background, built in recent decades usually along the lines of New Keynesian Economics. As the first generation of these new models became mature, though, the second generation started to be more detailed again. The recent third generation of models has added the aspect of stock-flow consistency, which has pushed the number of equations even further. The state-of-the-art forecasting models have consequently become quite big animals again, but their philosophical foundations remain very different from those of the 1950s to 1970s, as the third generation has extended the microeconomic foundations considerably. Secondly, the ever-changing world map in terms of monetary policy regimes has also modified the role of forecasting at central banks. In the past, most countries had pegged exchange rates against the major currencies. Under such a system, the role of forecasting is smaller than with the floating exchange rate regime and concentrates on balance of payments analysis and perhaps also monetary analysis. The countries with floating exchange rates, on the other hand, often experimented with money targeting, which pushed monetary analysis to the forefront. However, since the early 1990s the number of countries with floating exchange rates has increased dramatically, reflecting numerous currency crises and a growing consensus on the undesirability of conventional currency pegs. Moreover, the inflation targeting regime has gained much more weight among the group of countries with floating rates.