1. Borek Vasicek Universitat Autonoma de Barcelona XXXIII Symposium of Economic Analysis Zaragoza, December 11-13 2008 Monetary policy rules and the inflation process in open emerging economies: evidence for 12 new EU members

2. 1. Introduction  New Keynesian policy model (NKPM) – monetary policy rule, Phillips curve and IS curve - became the main tool for monetary policy analysis  The empirical evidence is lagging behind the theory  Most evidence available for major economies (large and closed) and centers usually on one of the relations

3. Objectives:  Identification of the logic of short-term interest rate setting pursued by monetary authorities in 12 new EU countries (the de-facto monetary policy) between 1999 and 2007  Identification of the basic properties of the inflation dynamics of these economies  Evaluation of the suitability of the existing monetary policy arrangements for the domestic price stability (the conditional variance of inflation) 1. Introduction

4. 2. Background  Empirical research on monetary policy rules:  Simple backward-looking rule (Taylor, 1993)  Generalized forward-looking rule (Clarida et al., 1998, 2000)  Real-time problem (Orphanides, 2001)  Nonlinear rule (Dolado et al., 2004, 2005)  Time-varying rule (Assenmacher-Wesche, 2006, Kim and Nelson, 2006)  Open emerging economies (Mohanty and Klau, 2004, María-Dolores, 2005, Frommer and Schobert, 2006)

5. 2. Background  Empirical research on inflation dynamics:  Hybrid New-Keynesian Phillips Curve (Galí and Gertler, 1999, Galí et al., 2001)  Econometric deficiencies (Bardsen et al., 2004, Mavroeidis, 2005)  NKPC for open economies (Batini et al., 2005, Rumler, 2006)  Studies on small emerging economies, in particular CEEC mostly aim at related issues like exchange rate pass- through (Coricelli et al., 2006) or inflation persistence (Coricelli el al., 2007)

6. 2. Background  Specific situation of EU-12 (compared to other EM):  Small and very open economies  Economic transition during 1990’s drove discretional economic policy → instability of basic relations and structural breaks in time series  Forthcoming euro adoption → cease of independent monetary policy  The period when we can empirically analyze the monetary policy rules and inflation process is rather short and very recent (1999-2007)  Diversity of official monetary policy arrangements and exchange rate regimes

7. 2. Background  Monetary policy regimes in CEEC since 1999:  Inflation targeting – Czech Republic (1997), Poland (1998), Hungary (2001 + exchange rate target), Romania (2005)  Implicit inflation targeting – Slovakia (2005 - ERM II)  Monetary targets – Slovenia (2005 – ERM II), Romania (prior to 2005)  Exchange rate pegs – Estonia (currency board with euro, 2004 – ERM II), Latvia (currency board SDR, 2005 – ERM II), Lithuania (peg to USD/euro, 2004), Cyprus (peg to euro, 2005 - ERM II), Malta (currency basket, 2005 – ERM II), Bulgaria (currency board with euro)

8. 3. Empirical framework  Static backward-looking rule (Taylor, 1993) (1)  Forward-looking rule (Clarida et al.,1998) (2)  Interest rate smoothing (Judd and Rudebusch, 1998) (3)

9.  General linear form used for estimation (4)  Additional variables x  foreign IR  exchange rate  monetary growth  asset prices  long-term IR  GMM, HAC Consistent Covariances, 2 lags of regressors as IV (all variables treated as endogenous), pre-whitening by VAR(1) 3. Empirical framework

10.  Hybrid New Keynesian PC (Galí and Gertler, 1999, 2001) (5)  Open economy NKPC (Batini et al., 2005, Rumler, 2006) (6)  VAR studies on Exchange Rate Pass-Through (Gagnon and Ihrig, 2004, Campa and Goldberg, 2005) (7) 3. Empirical framework

11.  General form used for estimation (8)  hybrid form but β do not have to sum unity  inflation expectation is proxied by 1-lead of HP inflation gap  additional variables: exchange rate (NER, REER), foreign inflation, short-term interest rate  OLS (GMM) + GARCH (1,1) (9)

12. 4. Data and time series analysis  Quarterly data from 1999 to 2007 from Eurostat, European Central Bank (Statistic Data Warehouse) and national central banks  The time series used are:  Inflation rate: inter-annual change in HCPI  Short-term interest rate: average 3 month (overnight) interbank interest rate  Long-term interest rate: 10 year government bond yield  Output gap: deviation of GDP (industrial production) from the trend (HP filter)  Exchange rate: inter-annual change of NER/REER  Monetary growth: inter-annual change of M3 aggregate  Asset prices: inter-annual change of the share index

13. 4. Data and time series analysis  Unit Root analysis  Both single-equation and panel unit root tests Interest rate and inflation rates usually I(1)  Cointegration analysis  Augmented Engle-Granger test (1987) MPR - mostly between IR and inflation rates (foreign IR) PC - inflation, foreign inflation, IR  Granger causality test  Causality between domestic and foreign (euro) short-term interest rates – found for BUL, CZE, EST, LAT, LIT, MAL, SVK  Causality between short-term and long-term interest rate causality in each country – found for CZE, EST, SLO

14. 5. Results and comments Table 1: OLS estimates of generic backward-looking TR

15. 5. Results and comments Table 2: GMM estimates of policy rule with the highest explanatory power – countries with flexible exchange rates  Forward-looking specification has better fit in all cases but SVK, long-term inflation multiplier >1 in POL, ROM but <1 in CZE, HUN (additional response to euro interest rate in CZE – flexible IT?)  SLO – resembles rules of IT countries and response to the euro interest rate or monetary growth, SVK mimicks euro interest rate movements

16. Figure 1.: Short-term interest rate, HCPI inflation and change in stock index in Poland 5. Results and comments

17. Table 3: GMM estimates of policy rule with the highest explanatory power – countries with fixed exchange rates  Euro interest rate is the principal driver of domestic interest rates (consistently with the Granger causality and AEG cointegration test)  The exchange rate fixing pursued by means of interest rate peg (Obstfeld and Rogoff, 1996 vs. Benigno and Ghironi, 2007)

18. Figure 2.: Short-term interest rates in Estonia and the euro zone and Estonian HCPI inflation 5. Results and comments

19.  Comments on the monetary policy rules estimates  Importance of real economic activity is lower than in principal economies (no room for output stabilization or just downward bias due to the noise in the variable?)  Interest rate smoothing is lower than found for developed economies (is strong immediate response to inflation desirable for the policy credibility?)  No response to long-term interest rate (reflect country sovereign risk rather than inflation expectations)  No response to asset prices (more volatile and lesser share of household holdings in emerging economies)  No response to exchange rate (not very volatile, no negative effect on price stability, implicit response – CPI, depends on ERPT)

20. 5. Results and comments Figure 3: Identification of monetary policy shocks from the residuals

21. 5. Results and comments Table 4: OLS estimates of the open economy PC

22. 5. Results and comments Table 5: GARCH estimates of the variance equation of the open economy PC

23. Figure 4: Inflation rate and conditional inflation variance 5. Results and comments

24.  Comments on inflation dynamics and monetary policy  No distinct feature in the open economy PC estimates between the two groups of countries  GARCH(1,1) estimates point to different patterns in the conditional inflation variance – constant term (long-term variance) and GARCH term (impact of variance from the last period) significant in countries with exchange rate pegs  DIT seems to be preferable strategy (POL, ROM) - decrease in both inflation rates and conditional inflation variance  Countries with exchange rate pegs – de facto-import of the ECB monetary policy but it is not sufficient to leash domestic inflation pressures (but also deflation experience of LIT)  What strategy should the DIT countries use for euro adoption? 5. Results and comments

25. 6. Conclusions  The interest rate setting can be described by policy rule  Forward-looking policy rules with significant response to inflation in DIT countries vs. interest rate peg in countries with fixed exchange rate regimes  Revealed results not always consistent with the proclaimed policy regime  The inflation dynamics can be tracked by open economy PC  Both backward- and forward-looking term relevant  Relation between inflation and output gap in some countries and incomplete exchange rate pass-through in countries with flexible exchange rates  Different pattern of conditional inflation variance  Better performance of DIT countries than countries with exchange rate pegs

26. Borek Vasicek Universitat Autonoma de Barcelona XXXIII Symposium of Economic Analysis Zaragoza, December 11-13 2008 Monetary policy rules and the inflation process in open emerging economies: evidence for 12 new EU members