: Monetary Economics and the European Union. Lecture 5. Instructor: Prof Robert Hill. Inflation Targeting

Transcription

1 : Monetary Economics and the European Union Lecture 5 Instructor: Prof Robert Hill Inflation Targeting Note: The extra class on Monday 11 Nov is cancelled. This lecture will take place in the normal class time on Tuesday 12 Nov. 1

2 The sources used to prepare this lecture include the following: Kuttner K. (2004), A Snapshot of Inflation Targeting in its Adolescence, in The Future of Inflation Targeting, C. Kent and S. Guttman (eds.): The Reserve Bank of Australia, 2004, Allen W. A. (1999), Inflation Targeting: The British Experience, Handbooks in Central Banking, Lecture Series No. 1, Issued by the Centre for Central Banking Studies, Bank of England Bernanke B. S. (2003), A Perspective on Inflation Targeting: Why It Seems To Work, Business Economics 38(3). Mishkin F. S. (2010), Monetary Policy Strategy: Lessons from the Crisis downloadable at: 2

3 1. The Origin of Inflation Targeting Inflation targeting entails the announcement of a transparent quantitative goal for inflation. Countries adopting inflation targets have typically at the same time (give or take a few years) made their central banks independent. The governor of the central bank (rather than politicians) is made accountable for deviations from the stated inflation target. New Zealand was the first country to adopt an inflation target in Canada, Great Britain, Sweden and Australia also adopted inflation targets in the 1990s. More recently emerging economies such as Brazil, Chile, South Korea, Mexico, South Africa, the Philippines, Thailand, and transition economies such as the Czech Republic, Hungary and Poland have also adopted variants on inflation targeting. 3

4 Two notable exceptions are the US and EU. Neither the Federal Reserve nor ECB has adopted an explicit inflation target. The ECB is independent. Although it does not have an explicit inflation target, it does have an inflation goal. In 2003 it changed its inflation goal from below 2 percent to below but close to 2 percent. 2. The Rationale for Inflation Targeting (i) Central banks can no longer control the money supply. The Governor of the Bank of Canada, when inflation targeting was adopted, said that We didn t abandon monetary targets. They abandoned us. (ii) Since the 1970s it has been recognized that any tradeoff between inflation and output is transitory. Inflation is what a central bank should really care about. Might it not make sense therefore to target directly the variable of interest? 4

5 (iii) Since the 1970s the importance of expectations has been recognized. Transparent monetary policy and a clear commitment to low inflation (e.g., an independent central bank) helps keep the expected rate of inflation at a low level. (iv) An inflation target is easy for the market to understand and provides a clear focus for expectations. (v) An independent central bank with an inflation target has more credible inflation fighting credentials than a dependent central bank. Before an election, governments have an incentive to implement expansionary monetary policies. (vi) No country that has adopted an inflation target has since abandoned it. The adoption of inflation targeting has typically coincided with a significant and sustained fall in inflation. See Mishkin, Chapter 16, Figure 1. 5

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7 3. Communicating with the Market Inflation targeting central banks typically make public announcements of the inflation target, inflation forecasts, and the timeframe for achieving the target after short-run departures. Communications with the market can help manage expectations, and hence make monetary policy more effective. Note: communication only helps if it is consistent with actual monetary policy. Example: the Bank of England s communication strategy consists of the following: 7

8 (a) The Bank of England publishes each quarter an Inflation report, setting out the Monetary Policy Committee s analysis of recent economic trends and a forecast of inflation and output growth for the next two years (including standard errors). (b) The minutes of the monthly Monetary Policy Committee meetings are published. These minutes include all the arguments for and against the decision actually taken (i.e., whether to raise, lower or hold fixed interest rates). The minutes are analyzed in the newspapers and financial markets. (c) Members of the Monetary Policy Committee are frequently questioned by the Treasury Select Committee of the House of Commons. 8

9 (d) If the rate of inflation strays by more than 1 percentage point from its target of 2 percent, the Governor has to write an open letter to the Chancellor of the Exchequer explaining how the discrepancy arose, how long it is likely to persist and how the MPC plans to correct it. (e) Members of the MPC make frequent speeches about monetary policy all over the country. 9

10 4. Constrained Discretion The inflation targeting policy framework helps achieve the goal of constrained discretion (i.e., the central bank the freedom to stabilize output and employment in response to short-run shocks, while maintaining a strong commitment to keeping inflation low). Market expectations are important. The actual rate of inflation depends as much on market expectations as on monetary policy. A strong commitment to an inflation target gives the central bank greater leeway to respond to shocks without stirring inflationary expectations. Note: the only sure way of reducing inflationary expectations once they have risen is through a recession. Hence it is better to prevent expectations of inflation rising in the first place. 10

11 5. Modeling an Inflation Targeting Central Bank s Loss Function L = E t Σ i=0 β i [(π t+i π T ) 2 + λ (y t+i y*) 2 ] where L is the loss function. The lower the value of L, the better the performance of the central bank β i is the discount factor for year i π t+i is inflation in period t+i π T is the target inflation rate y* is the natural rate of output y t+i is output in period t+i λ determines the relative importance attached to the inflation target and output target. The inflation targeting regime is flexible when λ>0. That is, in this case the central bank does care to some extent about minimizing departures from the natural rate of output. 11

12 No central bank spells out its loss function precisely. The Taylor rule is derived from the loss function. It takes the following form: r = k + a π gap + by gap Strict inflation targeting corresponds to a situation where b=0. In practice, some central banks also take account of the output gap (Y gap ) when setting monetary policy. This is known as flexible inflation targeting. 12

13 6. Is There a Conflict between Price and Output Stabilization? Tough talking inflation targeting central banks (e.g., New Zealand, Chile, Canada and the UK) tend to either ignore the issue of output stabilization, or argue that price level stabilization implies output stabilization. Whether this is true depends on whether the shocks hitting the economy are demand or supply shocks. There is no conflict for demand shocks (e.g., changes in consumption, investment, fiscal policy, exports, imports). There is however for supply shocks (such as an increase in wages or the price of oil). 13

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15 7. What is the Right Level for the Inflation Target? The ideal rate of inflation is greater than zero for a few reasons. (i) Upward bias to inflation measurement - Quality change bias - New goods bias (ii) Greater real wage flexibility - Workers really dislike nominal wage cuts (iii) Fear of deflation - Deflation causes people to delay purchases and hence can trigger a recession. Monetary policy becomes less effective in the presence of deflation. (iv) Cost in terms of short-run unemployment of reducing inflation to zero See Table 2 and Figure 1 of Kuttner (2004). 15

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20 Types of inflation targets Point target (e.g., 2 percent) Band target (e.g., 1-3 percent) The advantage of a band target is that it is then clear if the central bank is meeting its target. A band also gives the central bank some discretion over what point in the band it aims for at any given time (e.g., to accommodate cyclical fluctuations in inflation). The horizon of the inflation target Example: suppose the forecast is that this year inflation will be above the target band and that next year it will be below the target band. What should the central bank do? 20

21 It depends at least partly on the time lag of monetary policy. If the time lag is a year, there is no point raising interest rates now. If instead the lag is only 6 months, then there may be a case for raising rates now. The central bank needs to manage the path of inflation relative to the target starting from the point where monetary policy bites. Kuttner (2004) in Figures 7 and 8 provides graphs of the time path of the interest rate and inflation target for Sweden and the UK. These graphs allow us to see how forward looking these central banks were with their monetary policy interventions. 21

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24 Which measures of inflation should be targeted? (i) Consumer price index (CPI) including mortgage interest payments (ii) Consumer price index (CPIX) excluding mortgage interest payments (iii) CPI including imputed rent for owner-occupied housing (iv) CPI excluding imputed rent for owner-occupied housing (v) Producer price index (vi) GDP deflator 24

25 8. What About Asset Prices? The case of Japan and its stock market bubble which burst in the late 1980s, and the current financial crisis provide clear examples of the relevance of asset prices to monetary policy. In retrospect it is clear that Japan should have raised interest rates in the 1980s as asset prices rose, even though inflation was less than 4 percent throughout this whole period. The stock market trebled between the end of 1985 and its peak in 1989 (see graph from Blanchard s book). The problem was that the prices of goods and services were fairly stable while asset prices rose very rapidly. 25

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27 Failure to act on a bubble by the central bank could lead either to inflation (people feel richer and spend more) or deflation (if the bubble bursts). The rapid rise in house prices in the US, UK, Ireland, and Spain since the 1990s, created similar problems. As in Japan, the bursting of these bubbles may lead to prolonged periods of deflation. Households are left with large debts, and banks with bad loans. If governments bail out the banks this can trigger a government debt crisis (as has happened in Ireland and Spain). Before the crisis there was a debate in the central banking literature over whether a central bank should lean against a bubble or simply clean up after it bursts. 27

28 The argument for cleaning is that it is hard to tell if a bubble is happening until after the bubble bursts. It was also argued that if the central bank can tell there is a bubble then so can the market, in which case the bubble should immediately burst (or at least start deflating). This argument is ridiculous. Mishkin (2010) draws a distinction between credit driven bubbles and irrational exuberance bubbles. The dot.com bubble was an example of the latter. Credit driven bubbles are much more dangerous, since when the bubble bursts borrowers default on their debts thus endangering the banking system. 28

29 From now on central banks will probably pay more attention to asset prices as part of their inflation targeting strategy. How can this be done? A central bank could target a combination of the CPI and the change in a stock market index ( SMI) and a house price index ( HPI). Z = θ 1 (CPI) + θ 2 ( SMI) + (1 θ 1 θ 2 ) HPI where Z is the target index, and θ 1 and θ 2 are parameters. A better alternative might be to include asset prices in the Taylor rule as follows: r = k + a π gap + by gap + c SMI + d HPI. Alternatively, the central bank can do this informally. It can simply say it is raising interest rates this month due to concerns over the housing market. The Reserve Bank in Australia has been doing this for 15 years. 29

30 9. Criticisms of Inflation Targeting (i) It makes no difference It is hard to reconcile this claim with Mishkin s Figure 1. This has not prevented people from trying [see for example Ball and Sheridan (2003)]. (ii) It leads to greater output fluctuations This is only true if the inflation target is inflexibly applied. This is not the case in most inflation targeting countries. They do still take account of the short-run impact on output when setting monetary policy. By helping to keep inflationary expectations under control, if anything it is more likely that inflation targeting reduces output fluctuations. 30

31 (iii) Potential inconsistency between stated and actual policy If an inflation targeting central bank also takes account of the impact of monetary policy interventions on output (as is typically the case), then it is not just inflation targeting. Ben Friedman (2004) argues that inflation targeting actually obscures a central bank s goals and policies. (iv) The inflation rate is only observed with a lag This is true. Under inflation targeting, central banks have to rely a lot on inflation forecasts. It is not clear how reliable these forecasts are. (v) Monetary policy only affects inflation with a lag (about two years) This is a problem for any monetary policy regime, not just inflation targeting. The central bank needs to have intermediate targets, both for itself and the market. 31

32 (vi) Inflation targeting central banks do not say anything about how rapidly they want to bring inflation back to the target rate after a departure (e.g., due to a rise in the price of oil). This brings us back to point (iii) and the relative importance attached by the central bank to inflation and output. (vii) Inflation targeting encourages central banks to ignore asset prices, with potentially disasterous consequences. If asset prices are brought in explicitly, it is not clear how this should be done (e.g., should it be into the inflation target or Taylor rule). If they are only brought in implicitly, then the inflation target loses some of its transparency. 32