The benefits and drawbacks of inflation targeting

Transcription

1 The benefits and drawbacks of inflation targeting A presentation of my research on inflation targeting ( ) Professorial inauguration lecture at the Norwegian School of Management (BI) February 14, 2008 Kai Leitemo

2 Inflation targeting Is a set of principles that guides the setting of the short-term interest rate by the central bank (Norges Bank) Objective: to stabilize the growth in the general price level around 2-2.5% without causing undue fluctuations in economic activity Strategy: how to achieve it (my research focus) Replaced regimes of monetary targeting or exchange rate targeting (in Norway around ) The most common way of organizing monetary policy in industrialized countries (either formally or informally (ECB, FED))

3 My research questions ( ) Will the manufacturing sector be more unstable under inflation targeting than under exchange rate targeting? Which strategy should be adopted by Norges Bank in order to reach the inflationtargeting objective? Is a simple aim-and-shoot strategy useful? If the central bank can commit to a simple Taylor-rule strategy, does the exchange rate contain useful information in an open economy? What should be the role of fiscal policy stabilization under inflation targeting? Model uncertainty: when the central bank is uncertain about how the economy works, how should its strategy and even target be amended? The Achilles heel of inflation targeting.

4 Inflation Targeting and the Manufacturing Sector Leitemo and Røisland, [Estimated ECM of the Norwegian Economy. Forward-looking exchange rate] Comparison of inflation and exchange rate targeting: Does inflation targeting cause more or less stability in the manufacturing sector? An important question (and objection to IT) in Norway at the end of the 1990s. Main argument against inflation targeting: A more fluctuating nominal exchange rate destabilizes the manufacturing sector. We show that the opposite might be true. The manufacturing sector is sensitive to real exchange rate fluctuations which may be more stable under inflation targeting. Under exchange rate targeting the only monetary stabilization channel is the real exchange rate channel which affects the manufacturing sector The interest rate channel is possibly destabilizing under exchange rate targeting (Walters effect)

5 Requirements of a good CB strategy The rule for all strategies: Use all available and relevant information in the most efficient manner. Make people understand your strategy (transparency) Make people believe that you will follow the strategy now and in the future (commitment and accountability) Simplicity might follow from the second and third requirement

6 A simple aim and shoot strategy Leitemo (2003,2006a and 2006b) Strategy that have been used by Norges Bank, Sveriges Riksbank, Bank of England and others: Set the interest rate so that if it remains unchanged, the forecast of inflation is equal to the inflation targeting at some fixed forecast horizon A seductively intuitive and simple strategy In general, deviates from the optimal strategy Time inconsistency: as time proceeds, the point of time at which inflation is expected to hit target is pushed forward in time, continuously postponing the return of inflation to target. The expected time before inflation has returned to target is longer than the forecast targeting horizon.

7 What role for the exchange rate as an indicator in the open economy? Leitemo and Söderström (2005). [New-Keynesian model with imperfect competition and nominal stickiness. Calibrated to Norwegian economy.] The exchange rate influences inflation and output strongly in an open economy. How should the CB react to it? The exchange rate incorporates information about private sector expected future interest rate setting and risk premium according to the UIP theory. There is little to be gained by including a response to the exchange rate given that the central bank commits to responding to CPI inflation and the output gap (Taylor rule) CPI inflation and output gap are sufficient indicators even in an open economy Result might however dependent on the degree of forward-looking nature of inflation and output A separate response to exchange rate is a strategy that is less robust to exchange rate uncertainty

8 What role for fiscal policy stabilization under inflation targeting? Leitemo (2004) [Neo-Keynesian theory model] Fiscal policy has traditionally been providing macroeconomic (output gap) stabilization under exchange-rate targeting. So also in Norway. Under inflation targeting, output gap and inflation are typically target variables for the central bank..

9 Data uncertainty Leitemo and Lønning (2006) How should the central bank approach uncertainty about the output gap? The real-time output gap is imprecisely measured (Orphanides, 2001) The output gap can be proxied with the rate of change in inflation

10 The monetary transmission mechanism Money supply Money demand Short term interest rate Foreign interest rates Term structure theory Long-term interest rate Exchange rate channel Exchange rates Direct exchange rate channel Indirect exchange rate channel Interest rate channels Fixed capital investment Consumption of domestic goods Expenditure switching channel Imported goods prices Imported goods Exchange rate cost channel Production capacity Aggregate demand Aggregate demand channel Productivity Innovations Labor supply Output gap (& marginal costs) Foreign demand Exports Direct exchange rate channel (cont.) Consumer price inflation

11 Model uncertainty This line of research: what to do when the central bank doubts its understanding of the economy Leitemo (2007) Addresses uncertainty about the degree of forward-looking price setting in a hybrid Phillips curve The first-order condition of monetary policy is highly dependent on the degree of forward-lookingness (Leitemo, 2008) The central bank is unable to commit and acts under discretion Welfare analysis: a central bank that believes inflation to be forward-looking will always improve on welfare Exactly reproduces the commitment equilibrium if the true Phillips curve is half forwardlooking and half backward-looking.

12 Model uncertainty Leitemo and Söderström (2008a, 2008b) Use robust control techniques in order to study how best to prepare for potential worst-kind misperception of the economy Intuition: No fine-tuning, but insure against bad outcomes Analytic method for derivation of the robust control policy Depending on the equation (of the model) the CB is doubtful about, monetary policy can either be more aggressive or less aggressive.

13 The Achilles heel (1): model uncertainty Kilponen and Leitemo (2008) Milton Friedman sceptical to inflation targeting in the 50s and 60s due to model uncertainty The link between the monetary instrument and prices is too uncertainty to operationalize monetary policy around an inflation target Our argument: if the CB is very uncertain about the model and insures against possible worst-kind deviations, the insurance premium measured in terms of loss of welfare may be high If sufficiently uncertain, better to operationalize (delegate) monetary policy through money base targeting than inflation targeting

14 The Achilles heel (2): the lags in the effect of monetary policy Kilponen and Leitemo (2007) The scepticism of Friedman is partly due to long and variable lags in the effect of monetary policy: prices react slowly to changes in the monetary instrument We show that the presence of implementation lags on part of the private sector renders the welfare optimizing discretionary inflation targeting policy even worse The CB overstabilizes output and understabilize inflation Money base growth targeting superior

15 Conclusions Inflation targeting well established Norges Bank is well ahead of most other CBs. It is vulnerable in its ambitions and complexity: easy to do mistakes (e.g., policy mistake of 2002/3 in Norway) trying to do too much avoid, avoid : overconfidence in understanding of the economy A prediction: will be replaced by price level targeting in 20 years time.