Interest Rate Forecasts in Inflation Targeting Open-Economies

Can the choice of the target inflation index in an open-economy affect the central bank ability to forecast the interest rate path? Adopting a New Keynesian set up where the central bank faces real-world model uncertainty, this paper shows that targeting the domestic price index instead of the consumer price index substantially improves the accuracy in the distribution forecast of the interest rate. The policy implication is that adopting the domestic price index may increase the central bank’s convenience of publishing the expected interest rate path.