How can an interest rate rule reflect real economic considerations?

Since March 2011 the projections published by the Magyar Nemzeti Bank have been prepared using the Monetary Policy Model (MPM), in which interest rates are determined endogenously as a function of macroeconomic variables. This paper explains the characteristics of the interest rate rule of the model. First, the interest rate rule assures that monetary policy stabilises inflation over the appropriate horizon (generally approximately eight quarters), that is, it achieves medium-term price stability. Second, it takes into account the considerations of the real economy (both directly and indirectly), that is, it does not make excessive real economic sacrifices to achieve its primary objective. We demonstrate through simulations in the MPM model that monetary policy can attach more weight to real economy considerations if it broadens its horizon, that is, if it becomes forward-looking. This means that if monetary policy looks through short-term surges in inflation, then in the event of an adverse cost-push shock it need not aggravate the slowdown of the real economy to combat inflation. Moreover, this forward-looking rule which neutralises only second-round effects provides for more favourable trade-off between the objectives of inflation and the stability of the real economy than a direct increase in the weight of real economy consideration in the interest rate rule.