Targeting versus instrument rules for monetary policy: What is wrong with McCallum and Nelson?

Abstract

In their paper "Targeting versus Instrument Rules for Monetary Policy," McCallum and Nelson critique targeting rules for the analysis of monetary policy. Their arguments are rebutted here. First, McCallum and Nelson's preference to study the robustness of simple monetary policy rules is no reason at all to limit attention to simple instrument rules; simple targeting rules may have more desirable properties. Second, optimal targeting rules are a compact, robust, and structural description of goal-directed monetary policy, analogous to the compact, robust, and structural consumption Euler conditions in the theory of consumption. They express the very robust condition of equality of the marginal rates of substitution and transformation between the central bank's target variables. Indeed, they provide desirable micro foundations of monetary policy. Third, under realistic information assumptions, the instrument rule analog to any targeting rule that McCallum and Nelson have proposed results in very large instrument rate volatility and is also, for other reasons, inferior to a targeting rule. © 2005, The Federal Reserve Bank of St. Louis.