Average inflation targeting and the interest rate lower bound

Focus

This paper studies the effects of average inflation targeting (AIT) on macroeconomic stabilisation in the presence of a lower bound. AIT has recently attracted increasing attention as a possible alternative to currently prevailing inflation targeting frameworks, notably because of its "make-up" feature, whereby past inflation shortfalls are made up for by temporarily higher future inflation and vice versa.

Contribution

Our paper contributes to the ongoing discussion of the benefits and costs of alternative monetary policy strategies. We consider the optimisation problem of a central bank whose objective function features the volatility of average inflation rates over a prespecified time period, as opposed to the current inflation rate. Our analysis is based on two variants of the standard New Keynesian model with an interest rate lower bound, one with rational expectations and one with boundedly rational expectations.

Findings

We find that AIT improves welfare considerably when agents form expectations rationally. Following a large recessionary shock that drives the policy rate to the lower bound, a central bank with an AIT objective engineers a temporary overshooting in future inflation that helps to mitigate the decline of output and inflation at the lower bound via the expectations channel. Under rational expectations, the optimal averaging window is infinitely long, which implies that optimal AIT is equivalent to price level targeting. However, we find that most of the welfare improvement associated with the optimal AIT can be attained by an AIT objective with a finite, but sufficiently long, averaging window. The results from the rational expectations model are robust to including plausible degrees of bounded rationality. However, if cognitive limitations are sufficiently large, the optimal averaging window is finite and the welfare gains from adopting AIT can be small.

Abstract

Assigning a discretionary central bank a mandate to stabilize an average inflation rate - rather than a period-by-period inflation rate - increases welfare in a New Keynesian model with an occasionally binding lower bound on nominal interest rates. Under rational expectations, the welfare-maximizing averaging window is infinitely long, which means that optimal average inflation targeting (AIT) is equivalent to price level targeting (PLT). However, AIT with a finite, but sufficiently long, averaging window can attain most of the welfare gain from PLT. Under boundedly-rational expectations, if cognitive limitations are sufficiently strong, the optimal averaging window is finite, and the welfare gain of adopting AIT can be small.

JEL classification: E31, E52, E58, E61, E71

Keywords: monetary policy objectives, makeup strategies, liquidity trap, deflationary bias, expectations