Monetary policy and self-fulfilling expectations: the danger of forecasts

Abstract

What rule should a central bank interested in inflation stability follow? Because monetary policy tends to work with lags, it is tempting to use inflation forecasts to generate policy advice. This article, however, suggests that the use of forecasts to drive policy is potentially destabilizing. The problem with forecast-based policy is that the economy becomes vulnerable to what economists term “sunspot” fluctuations. These welfare-reducing fluctuations can be avoided by using a policy that puts greater weight on past, realized inflation rates rather than forecasted, future rates.