BIS Review 10/2007  13  In this example, we have been able to reconstruct (approximately) the reference path in Inflation Report 3/06 by minimising a loss function under commitment in a timeless perspective. To reconstruct the reference path, the weight on the output gap in the loss function, lambda, has been set at 0.3. We also had to place a weight on changes in the interest rate in the loss function. This weight, which penalises large changes in the interest rate, can be defended based on considerations regarding robustness and financial stability. What is the outcome if we depart from our established response pattern? 14  BIS Review 10/2007  The chart illustrates what might happen if the central bank reoptimises today, but promise never to do so again. In the model, this will result in a marked rise in interest rates today. But such an approach has been criticised in the literature. If the central bank departs from its response pattern today, it is easy to believe that it will do the same in the future. It may therefore be difficult to gain credibility for such a policy. Even if it may feel tempting, it is important to be aware of the costs associated with departing from an established response pattern. It will then be more demanding to influence private-sector expectations. Frequent reoptimisations will in practice undermine the benefit of commitment and lead to a discretionary policy. The benefit of commitment hinges on the credibility of the central bank’s actions and communication.
As long as private-sector decisions are partly based on expectations about the future, and the central bank through its actions and communication can influence these expectations, the chart illustrates a result that is independent of the explicit economic model: If the central bank can commit itself credibly to a response pattern, it will be able to achieve a better outcome over time than if in each period it attempts to optimise the situation. This is illustrated in the chart in that the line that represents a commitment strategy lies closer to the origo point than the line that represents a discretionary strategy. If, however, economic agents are purely backward looking, there would not be any differences between the two approaches, and the two lines would converge into one. The more forward-looking the economic agents are, the greater the difference between the outcomes is. The way in which monetary policy is implemented and communicated may therefore influence the functioning of the economy through the expectations channel. By committing to a pattern of behaviour, the expectations channel can be used effectively. BIS Review 10/2007  11  Let us now take a closer look at our projections in the previous Inflation Report. The inflation gap closes gradually from below, while the output gap closes from above. According to the Bank’s view, these paths provide a reasonable trade-off between the objective of stabilising inflation at target and stabilising developments in output and employment. Let us now use a time machine and travel forward to 2008.