Presentation on theme: "Inflation Targeting and Monetary Policy Rules: Experience and Research"— Presentation transcript:
1Inflation Targeting and Monetary Policy Rules: Experience and Research John B. TaylorStanford UniversityPresented at the 12th Meeting of the Latin American Network of Central Banks and Finance MinistriesInter-American Development BankMay12, 2000
2Outline Conceptual Issues Recent experience in U.S. and other countriesDescribing the decisions as policy rulesResearch methodologyResearch resultsKey threshold for response to inflationRobustnessInflation forecast based rules and forecast targetingExchange ratesGap uncertaintyAsset price bubblesZero interest boundsConclusions
3Inflation targeting Choose an inflation target: * Explicit? Numerical? Implicit?Keep inflation rate “close” to the targetIn mathematical terms: minimize, over a “long” horizon, the loss function:w1(t - *)2 + w2 (yt – yt*)2 + w3 (et – et*)2Does not imply that w2 = 0, sometimes called “strict”Does imply that y* = “natural” rate of output
4But inflation targeting is not enough, need to say something about the policy instruments Analogy:Targeting the destination for a sailboat versus saying how to sail the boat to the destination in a short time:angle of attack, sail trim, contingency for wind change,…Many alternatives to achieve an inflation target:Fixed money growth“Permanently” fixed exchange rate“Active” crawling pegInterest rate ruleExchange rate ruleMonetary conditions index rule
5Recent Experience: U.S. 2000 will be 18th year of the “Long Boom” First and second longest peacetime expansions in U.S. history1991- ,Recession in between was short and mildInflation has been low and stableNo period of macroeconomic stability like this before17 years before this ( ) had 5 recessionsBefore 1982 in recession 35 percent of the timeSince 1982 in recession less than 4 percent of the time
6percent20Real GDP growth rate (Quarterly)15105-5-106065707580859095
7percent42-2GDP gap with HP trendfor potential GDP-4-66065707580859095
8Why the Increased Stability? Good luck?No big shocks like the 1970s?But shocks were big several timesLate 1980s credit crunch1998 currency crises,Now viewed as favorable supply shocksChange in the economic structure?Services, inventories, high-tech “new” economyGood policy?Fiscal policy?Deficit reduction and elimination?Keynesian counter-cyclical policy?
9U.S. monetary policy has changed More reactive to changes in inflationfederal funds rate rises by twice as much when inflation rises: 75 versus 150 basis pointsThis more prompt, more reactive policy, has kept inflation from rising, thereby preventing recessions.For example, compare the funds rate changes in the late 1980s and the late 1960s
10Smoothed inflation rate (4 quarter average) 8 12Inflation rate10Smoothed inflation rate(4 quarter average)861968.1: Fundsrate was 4.8%1989.2: Fundsrate was 9.7%4260657075808590
11Many other Experiences Inflation/Output Stability Before and After Inflation Targeting (percent) Source: Cecchetti and Ehrmann(1999)PeriodinfgrowthBefore:15.07.5After:3.36.9Difference11.70.6AustraliaCanadaChileFinlandIsraelNew ZealandSpainSwedenU.K.
12Describing Decisions for Policy Evaluation Purposes Change overnight rate if:(1) Inflation moves away from target(2) Real GDP moves away from trend (potential)Little mention of money growth or exchange ratesDecisions are pretty well described by Taylor rule:Interest rate = inflation +.5(inflation – 2) + .5(GDP gap) + 2
13Use of Policy Rules in Practice Of course, no policy rule can be followed mechanicallySpecial factorsNeed to estimate potential GDP growthBut can be used as a guideline in many casesOr, more complex actions are approximated by a simple rule.Example, inflation forecast targetingUseful for private sector too
14Example: Interest Rate Analysis of U.K.by PriceWaterhouseCoopers If growth was left unchecked it could lead to an acceleration of inflation to over 4% in Using a simple Taylor rule, we estimate that interest rates would eventually need to be raised to around 7.5% by early 2001In contrast, if the UK recovery stalls next year then inflation is likely to fall further below target. Our Taylor rule simulations suggest that interest rates might then need to be cut to only around 4% by early 2001
15- improved economic climate - increased inflation risks. On November 4, the European Central Bank raised the overnight rate by 50 basis points from 2.5 to 3.0 percent.Rationale:- improved economic climate- increased inflation risks.Source:
16- Increased inflation forecast - Stronger economy On November 12, the Swedish Riksbank raised the overnight rate 35 basis points from 2.9% to 3.25%.Rationale:- Increased inflation forecast- Stronger economySource:www.dglux.lu/en/505.htm
17On November 3, the Reserve Bank of Australia raised the overnight rate 25 basis points to 5% on 3 November,Rationale:- Inflation concerns- Strong economySource:
18- Inflation increasing. On January 19, the Reserve Bank of New Zealand raised the overnight rate 25 basis points to 5.25%.Rationale:- Inflation increasing.Source:
19Methodology for Research on Monetary Policy Rules Stick a policy rule into a modelHaving models at the central bank is importanteg; Brazil, Canada, Sweden, U.S.Solve the modelLook at the behavior of the variables (inflation, real output, exchange rate)Choose the rule that gives the most satisfactory performance (optimal)Check for robustness using other models
20Important Threshold Result: Slope Should be Greater 1 Interest rateConstant RealInterest RatePolicyRuleInflation rateTargetImportant Threshold Result: Slope Should be Greater 1
22Inflation Forecast Based Rules it = g(Ett+j) for some j where E is the forecastModel or judgementalCan’t see future so based on current and lagged infoA way to put weight on output: Choosing a longer horizon (j) is like putting more weight on output.For j = 6 not as good as simple rules in ECB simulations (Taylor, 1999)Optimal choice of j appears to be very small, and too large a j is not robust ( paper by Levin, Weiland, Williams presented at ECB conf.)For j>2 there is great uncertaintyNot as robust as rules with j = 0 and output gap
23Inflation forecast targeting Set it so that Ett+j equals * or approaches it gradually over the timeMuch less formal research on this procedurenot a rulehard to simulateWoodford’s Jackson Hole commentBut in practice there is a role for forecastingBoth inflation and real GDP growthForecasting model at central bank needs to imbed threshold resultInflation Reports as in U.K. and Brazil are useful
24Exchange rate regimesFlexible exchange rates cum monetary policy rulesSeveral models in research studies have the exchange rate channel as part of the transmission mechanism and perfect capital mobilityBut rule without exchange rate is still pretty robustMy suggestion for a rule for the U.S. was based on a multicountry model with exchange rate channelBut much more research is neededExchange rate variations are more costly in small open economy with foreign currency denominated debtUsing exchange rate to affect inflation directly
25Put exchange rate in policy rule One approach: Place exchange rate into interest rate ruleit = gt + gyyt + ge0et + ge1et it-1whereit is the nominal interest rate,t is the inflation rate (smoothed over four quarters),yt is the deviation of real GDP from potential GDP,et is the exchange rate (higher e is an appreciation).
27Uncertainty in Measuring Potential GDP Uncertainty is very large:Gap range is now 0 to 3 for U.S.Solutions:Add research funds to get better estimatesReduce weight on gap (Frank Smets’ ECB study)Use growth rate rather than gap: big debate here
28Interest rate hitting zero problem Downward spiral…To estimate likelihood of hitting zero and getting stuck, put simple policy rule in policy model and see what happens:pretty safe for inflation targets of 1 to 2 percentModify simple rule:Interest rate stays near zero after the expected crises (Reifschneider and Williams (1999))
29The Downward Spiral Problem Interest rateConstant RealInterest RatePolicyRuleInflation rateTargetThe Downward Spiral Problem
30Should central banks try to break stock price bubbles? Add a stock price term to simple policy rulesimulations show that reacting to this term increases output and inflation variabilityBut some sharp changes in asset prices may require discretionary increases in liquidity1987 stock market crash in U.S.1998 reaction to change in risk premium...
31Conclusion Inflation targeting is not enough Implementing inflation targeting in practice requires analysis of how the instruments of policy should be changedInterest rate policy rules are a way to implement inflation targetingLots of research about the form of policy rulesResearch needed on how policy rules are to be used:Guidelines? Part of IMF programs? Private sector monitoring?More research is needed on exchange rate issues in highly open economiesFlexible exchange rates with a monetary policy rules provide a lot of room between the “corner solutions”