Clayton, Christopher and Schaab, Andreas (2022) A Theory of Dynamic Inflation Targets. TSE Working Paper, n. 22-1389, Toulouse

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Abstract

Should central banks’ inflation targets remain set in stone? We study a dynamic mechanism design problem between a government (principal) and a central bank (agent). The central bank has persistent private information about structural shocks. Firms learn the state from the
central bank’s reports and form inflation expectations accordingly. A dynamic inflation target implements the full-information commitment allocation: the central bank is delegated the authority to adjust its own target as long as it does so one period in advance. Both the level and
flexibility of the dynamic inflation target respond to persistent shocks. Target flexibility is set to correct the time consistency problem, while the target level provides the correct incentives for target adjustments. An informational divine coincidence arises: the central bank’s incentives to misreport its persistent private information to manipulate firm and government beliefs exactly offset each other under the mechanism. We apply our theory to study lower bound spells, a declining natural interest rate, and a flattening Phillips curve. We leverage our framework to study longer-horizon time consistency problems and speak to practical policy questions of inflation target design.