Optimal control typically involves the selection of a particular model to represent the dynamics of the economy as well as the specification of a “loss function” that represents the social costs of deviations of inflation from the Committee’s longer-run goal and of deviations of unemployment from its longer-run normal rate.
In effect, this approach assumes that the policymaker has perfect foresight about the evolution of the economy and that the private sector can fully anticipate the future path of monetary policy; that is, the central bank’s plans are completely transparent and credible to the public.9 To show what an optimal control approach might have called for at the time of the January FOMC meeting, figure 7 depicts a purely illustrative baseline outlook constructed using the distribution of FOMC participants’ projections for unemployment, inflation, and the federal funds rate that we published in January.