Survey_BW_2006

Abstract

We formally characterize ECB-style cross-checking using a policy rule with two components. The first component aims to control inflationary risks based on a standard Phillips curve and aggregate demand relationship. Essentially, it is the optimal interest rate rule of an inflation-targeting central bank. If implemented successfully this rule should ensure that inflation averages around the central bank’s inflation target. Its weakness is that it relies on knowledge of unobservables such as the equilibrium real interest rate and potential output that may be subject to large and persistent policy misperceptions. The second component captures the idea of cross-checking using the long-run relationship between money and inflation. We assume that the central bank checks regularly whether a filtered money growth series adjusted for output and velocity trends averages around the inflation target. If the central bank obtains successive signals of a sustained deviation o inflation from target it adjusts interest rates accordingly. Our simulations indicate that persistent policy misperceptions regarding potential output induce a policy bias that translates into persistent deviations of inflation and money growth from target. In this case, our “two-pillar” policy rule may effectively overturn the policy bias. Cross-checking relies on filtered series of actual money and output growth without requiring estimates of potential output. Nevertheless, it leads to adjustments in interest rate policy that offset the bias resulting from policy misperceptions. Indirectly, however, it helps the central bank to learn the proper level of interest rates.