RDP 2025-02: Boundedly Rational Expectations and the Optimality of Flexible Average Inflation Targeting 6. Conclusion

It is widely recognised that rational expectations is a strong assumption and many researchers and policymakers have worried that policy recommendations that rely on it may not be robust. A large literature has shown that this concern is warranted in a variety of settings. We show that, in a framework encompassing a broad set of theories of expectation formation, flexible average inflation targeting is a robust policy strategy. Whether the central bank is unconstrained, faces information constraints or the ZLB, it is optimal to target a weighted average of inflation.

In addition, the optimal target criteria we derive give clear guidance on when policy should be flexible and deviate from the policy implied by the weighted average of inflation alone. If expectations drift in ways that are inconsistent with policymakers' objectives, then pre-emptive actions should be taken, with more agressive policy now to re-anchor beliefs. If targets are missed today, then policy should do more to make up for the misses in the future. If targets are expected to be missed in the future because of the constraint of the ZLB, then policy should do more today to insure itself against the possibility of a prolonged period of constrained actions. This guidance summarises what the flexible in FAIT should mean.