Inflation Targeting: A New Monetary Policy Framework in Korea. October Junggun Oh The Bank of Korea

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1 Inflation Targeting: A New Monetary Policy Framework in Korea October 2000 Junggun Oh The Bank of Korea

2 Inflation Targeting Framework Korean Experiences in Inflation Targeting

3 Inflation Targeting Framework Basic Framework Rationale behind the Adoption of IT Necessary Conditions for IT

4 Basic Framework of IT An inflation target is decided in a medium term perspective. A future inflation rate is forecast A short-term interest rate is used as operating target, without an explicit intermediate target, to achieve the inflation target taking into account the forecast inflation.

5 Inflation Targeting and Intermediate Targeting Inflation Targeting Policy Operating Policy Goals Instruments Targets or Objectives Information Variables Intermediate Targeting Policy Operating Intermediate Policy Goals Instruments Targets Targets or Objectives

6 Some Common Facts First, independence of the central banks and transparency of monetary policies of the inflation targeting countries have been enhanced. On the other hand, the inflation targeting countries tend to separate from the central banks the function of financial supervision previously belonged to the central banks.

7 It is, however, widely reported that more detailed information on financial markets and financial institutions which can be collected during financial supervision is useful and important to enhance the effectiveness of monetary policy even in the normal period. In the period of financial crisis, central banks need detailed information on financial markets and financial institutions to play an appropriate role as a lender of last resort. Accordingly, although the primary objective of central banks in inflation targeting countries is not financial stability but price stability, it is desirable for the central banks to maintain some function of financial supervision

8 Second, an inflation targeting system with a freely floating exchange regime is popular. The issue is, however, whether the central bank of a small open economy can disregard the volatility of the exchange rate considering the current account and financial stability in the country

9 Third, in some developing inflation targeting countries, the interest rate channel of monetary transmission is still weaker. They need to develop monetary policy instruments and financial markets, and to prevent the government from intervening the financial markets.

10 Fourth, In some developing inflation targeting countries, there are the problems of, sometimes hidden, public debts, which impose a burden on achieving price stability. Fifth, most inflation targeting countries adopt the inflation targeting system during a currency crisis when the inflation rate is high due mainly to devaluation. Consequently, it is not easy, in the short run, to assess whether the low inflation rate after the crisis is attributable to appreciation or inflation targeting.

11 Rationale behind the Adoption of the Inflation Targeting System First, in policy perspective, Central banks generally carried out monetary policy in the 1970s making use of an intermediate targeting system The rapid financial innovation and liberalization in the 1980s blurred the distinctions between the monetary aggregates and destabilized the relationship between the real sector and monetary aggregates, greatly reducing the effectiveness of this method of conducting monetary policy

12 Second, in a theoretical perspective, higher inflation is detrimental to economic growth, and that there is no negatively sloped long-run trade-off between inflation and growth. Excessively high inflation variability reduces the credibility of monetary policy, which increases inflation expectations, which in turn will increase the costs of bringing inflation back

13 Necessary Conditions for IT Central Bank Independence Capacity of Inflation Forecasting Controllability of the Central Bank over Operating Targets Effective Channel of Interest Rates on Prices Transparency, Consistency and Credibility of Monetary Policy

14 Central Bank Independence Low CBI -> Time Inconsistency Problem ->High Levels of Inflation and High Variance of Inflation Rates Legal Independence Goal Independence Operational Independence Political Commitment to Price Stability

15 Capacity of Inflation Forecasting Due to the lag in the monetary transmission mechanism, control over inflation requires an inflation forecast. In particular, an IT system is a forward looking pre-emptive framework for monetary policy based on a medium-term inflation forecast. Increasing uncertainty makes it more difficult to forecast the future inflation Forecasting Model Inflation Pressure Indexes

16 Controllability of Monetary Policy Instrument over Operating Targets Establishing the relationship between monetary policy and the operating target is just an issue of whether the central bank has control over the operating target. Development of short-term money markets and indirect monetary policy instruments are important to strengthen the controllability

17 Effective Channel of Interest Rates on Prices A close relationship between an operating target and a final target such as price stability is crucial since an intermediate target is not explicitly employed It is important whether there is a transmission channel through which the short-term interest rate affects prices.

18 Transparency, Consistency and Credibility of Monetary Policy Needs to introduce measures to change conventional inconsistent and nontransparent monetary policies and to increase the reputation of central banks in DCs. Publication of the Inflation Report Disclosure of the Minutes of the MPC Meeting Answer to the Questions by the Parliament Understanding of Underlying Inflation by the Public

19 Credibility and Flexibility of Monetary Policy Some trade-off between credibility and flexibility. The design of the inflation targeting system, such as targeting bands and the policy horizon. A more scientific way of implementing monetary policy to reflect the optimal degree of tradeoff between credibility and flexibility

20 D E õ@/:

21 Some procedure for setting the interest rate instrument: A discretionary monetary policy rule: The Taylor Rule A guideline for the implementation of inflation targeting

22 The Taylor Rule * r t r π t π y t * * y t * t r = r+ σ ( π π ) + σ 1 : Nominal short-term target interest rate : :Nominal long-term equilibrium interest rate : Inflation Rate at the period of t :Target Inflation Rate : Real GDP : Potential GDP t * 2 ( y t y * t )

23 The Taylor rule can be derived from the reaction function of central banks by the following simple model which consists of a Phillips curve, aggregate demand equation and the central bank's loss function: π + t * = π t 1 + α ( y t 1 y t 1 ) ε t y t * * = yt + ( yt 1 yt 1 ) γ ( rt 1 r) β + η t L t = E t t = 0 δ t [ + ] * 2 * 2 (1 λ )( π π ) λ ( y y ) t where is inflation, * is the inflation target, y is output, y * is potential output, r is the short-term interest rate which is assumed to be the instrument of monetary policy, is a discount factor, and t and ñ t are i.i.d. shocks which are not known to the policy-maker when the interest rate in time t is chosen. r * is the long-term equilibrium interest rate. t t

24 Korean Experiences in Inflation Targeting Background to the Adoption of IT in Korea Necessary Conditions for IT in Korea IT System in Korea Assessment of the Korean Experiences in Inflation Targeting

25 Background to the Adoption of IT in Korea Decrease in the effectiveness of the rate of increase in M2 as the intermediate target of monetary policy Shift in the main transmission channel form the monetary channel to the interest rate channel

26 Decrease in the Effectiveness of the Monetary Aggregate Years first half Monetary Target Variables Monetary Target Variables M second half Reserve money Domestic credit M1 M M2 and MCT Twin Intermediate Targets M3 Indicative Limit

27 Monetary Aggregate Targets* and Their Performance Years ** 1999** 2000** ** Indicative Limit of M3 Targets * M2 except the years from 1998 to 2000 Actual

28 The Rates of Increase in Monetary Aggregates O c ^`_ J; J ;9 :9 9 6:9 :< : :< : :< <: :<<9: :<<:: :<<;: :<< : :<< : :<< : :<< : :<< : :<< : :<<<: ;999: 6;9 6 9

29 The Share of M2 in M3 :99 2 < ;9 J; :9 9 :< : :< : :< : :< <: :<<9: :<<:: :<<;: :<< : :<< : :<< : :<< : :<< : :<< : :<<<: ;999:

30 Variance Decomposition from 3 variable VAR Model (Money, Interest rate and GNP Deflator) (%) M2 Corporat e Bond Yield M2 Corporate Bond Yield GNP GNP deflator

31 Results of Forecast Error Variance Decomposition of Prices (C P I) ( ) :99 DII 9 IJ 9 9 I MF ;9 I M 9 : :: : ;: ; : : :

32 Necessary Conditions for IT in Korea Central Bank Independence Capacity of Inflation Forecasting Controllability of the Central Bank over Operating Targets Effective Channel of Interest Rates on Prices Credibility and Flexibility of Monetary Policy

33 Central Bank Independence The Bank of Korea Act was fully revised in 1997 to establish the neutrality and autonomy of monetary policy. The Governor of the Bank of Korea has become the chairman of the Monetary Policy Committee, who was formerly the Minister of Finance and Economy. In that sense, legal independence has been secured Every year the Bank of Korea sets a price stability target for the next year in consultation with the Government before the end of the year, and then independently formulates and promulgates an operation plan for monetary and credit policies including this price stability. Accordingly goal independence also can be said to have been established.

34 Finally every month the Monetary Policy Committee of the Bank decides the Monthly Monetary Policy Direction and then the Bank implements monetary policies in line with the Direction. Therefore operational independence is also secured. However it has been, in part, pointed out that monetary policies of the Bank should be implemented more independently of the implicit or explicit government, political and social pressures

35 Capacity of Inflation Forecasting The Bank of Korea has developed a series of macroeconometric models of the Korean economy since the early 1970s, revising the models every three or five years, and utilizing them extensively in analyzing the effects of monetary policy and predicting future economic trends. Structural models Monthly and short-term forecasting models (quarterly models) and then annual long-term forecasting model Time series model VAR and RegARIMA models for forecasting. Large-scale sectoral models in such areas as the price, financial, fiscal and external sectors In addition, the Bank studied inflation pressure for monetary policy

36 Main Purpose Sample Periods Seasonal Adjustment No. of Equatio ns Exogeneous Variables Estimated Variables Monthly Forecasting Model (97.7) BOK97MD Monthly Forecasting BOK97MS Rate of increase compared with the corresponding previous year 7 6 GDP & Components 3 3 GDP, GNP, Non-Agricultural GDP Shortterm Forecasting Model (97.7) Structural Model Time Series Model BOK97L Quarterly Forecasting X12- ARIMA BOK97G Rate of increase compared with the corresponding previous year VAR Dummy Variables RegARIMA Four Quarters Lagged GDP &, Components, BOP None GDP 1 GDP Short-term Model (97.4) Annual Model (97.12) BOK97 BOKAM97 Policy Analysis Medium and Long-term Forecasting X11- ARIMA GDP & Components, BOP, Prices

37 Controllability of Monetary Policy Instruments over Operating Targets Granger Causality F-value Significance level RPs (1 day) -> Call(11day) MSBs (1day) -> Call(11day)

38 Controllability of Monetary Policy Instruments over Operating Targets

39 Effective Channel of Interest Rates on Prices Impulse Response of the Call Rate on Prices Results of Forecast Error Variance Decomposition of Prices

40 Impulse Response of the Call Rate on Prices Response of LCPI to CALL Response of LUCPI1 to CALL Response of LUCPI2 to CALL Response of LUCPI3 to CALL

41 ] Results of Forecast Error Variance Decomposition of Prices C P I :99 DII 9 IJ 9 9 I MF ;9 9 I M : :: : ;: ; : : :

42 Credibility and Flexibility of Monetary Policy Some trade-off between credibility and flexibility. The design of the inflation targeting system, such as targeting bands and the policy horizon. A more scientific way of implementing monetary policy to reflect the optimal degree of tradeoff between credibility and flexibility

43 Interest Rate Rule Based on the Inflation Rate Dynamic Reaction Function CALL t = INFGAP GDPGAP + (2.894) (2.881) (2.002) CALL t-1 (2.089) R bar 2 = Interest Rate Rule CALL t* = INFGAP GDPGAP

44 Interest Rate Rule Based on the Underlying Inflation Rate 1 Dynamic Reaction Function CALL t = INFGAP GDPGAP (2.485) (2.301) (1.390) CALL t-1 (1.590) R bar 2 = Interest Rate Rule CALL t* = INFGAP GDPGAP

45 IT System in Korea The Adoption of IT The Use of an Underlying Inflation Rate The Introduction of a Mid-term Inflation Target Transparency, Credibility and Accountability The Inflation Target for 2000

46 The Adoption of the Inflation Targeting System In Korea, the inflation targeting system was first introduced in 1998 under the provisions of the fullyrevised Bank of Korea Act of The new Act declared price stability as the sole objective of the Bank of Korea. Under its provisions, the Bank of Korea is required to set an inflation target every year and do its best to achieve it. The Bank of Korea has set an annual target since 1998

47 BOK adopted CPI in 1998 as the Benchmark Indicator The CPI is, however, seriously affected by temporary or transitory shocks such as natural disasters or sharp fluctuations of international oil prices.

48 Taking this into consideration, when setting the inflation target for 1999, the Bank of Korea added a provisory clause to exclude changes in the inflation rate caused by force majeure such as price fluctuations of agricultural products attributable to natural disasters and price adjustments due to the revision of tax legislation. However, there were no specific descriptions and objective criteria attached as to which situations could be acknowledged as cases of force majeure and no procedures that could be applied in dealing with cases of force majeure.

49 The Use of an Underlying Inflation Rate Reviewing this situation, the Bank decided to adopt the CPI as the benchmark inflation indicator in setting its inflation target for 2000, but to clarify the provisory clause so that monetary policy should be formulated and implemented on the basis of the underlying trend of prices. There are various methods of adjusting the CPI to find the underlying trend of prices. Among them, the most popular method is that of excluding items of the CPI which are most highly volatile in response to external shocks.

50 Stability and Usefulness for Monetary Policy of Underlying Inflation Rates (Sample Period: 1990~98) Stability Usefulness for Monetary Policy Increase Rates on Average (%) RMSE Coefficients 1) Of Variation Case 1 2) Case 2 3) Cross Correlation with the Call Rate Transmission Effects of a Call Rate Shock Results of Variance Decomposition Long-run Multiplier (Call Price) Rate of Increase In C P I Negative With 4 quarters lag Lowest in the 4th quarter after the shock and then rises The effects of a change in the call rate appear in the 3rd quarter and persist for a long time Negative Value ( ) Underlying Inflation Rate Negative with 3 quarters lag Negative Value ( ) Underlying Inflation Rate 2 Underlying Inflation Rate Negative With 4 quarters lag Falls in the 2nd quarter after the shock, and lowest in the 15 th quarter after the shock The effects of a change in the call rate are not clear Negative Value ( ) Negative Value ( ) Notes: 1) The RMSE from the long-run trend of the rate of change in CPI. 2) The rate of change in the HP filtered CPI is used as the long-run trend. 3) The five-year moving-average of the rate of increase in CPI estimated with the SVAR model is used as the long-run trend. Source: Oh, Junggun (1999)

51 The Bank of Korea judged this method best suited for the adjustment of the CPI in Korea, On the basis of historical data and experience, the Bank decided to strip out from the CPI index the price changes of petroleum fractions and agricultural products except cereals.

52 The Introduction of a Mid-term Inflation Target The Bank of Korea used a short-term inflation target with a one-year time horizon when it established the inflation targets for 1998 and However, there is a time lag in the monetary policy transmission mechanism. Accordingly, monetary policy focusing only on the shortterm inflation target for one year would have a great deal of difficulty. Also such a myopic monetary policy could not give the public the confidence that the central bank will implement monetary policy consistently to keep the inflation rate stable over the mid-term horizon.

53 The Bank of Korea therefore resolved to set, in addition to an annual inflation target for the coming year, a mid-term inflation target from 2001 onwards, so as to maintain the consistency of monetary policy over the medium term. The mid-term inflation target was set at the same level as or lower than the short-term inflation target for the year in order to inspire confidence that the Bank would keep inflation low and stable in the long run The mid-term target was quoted as a point target without a toleration band, to demonstrate the strong commitment of the central bank to prevent the spread of inflationary expectations among the public than to take economic uncertainties into account.

54 . The Bank set the mid-term inflation target from 2001 as 2.5 per cent level on an annual average basis each year after Bias in the Measurement of Inflation Rate Risk of Deflation Rigidity of Nominal Wages Inflation -> Decrease in Real Wage -> Increase in Labor Demand NAWRU (Non Accelerating Wage Rate of Unemployment): 4% In 2000, Unemployment rate: 4% Inflation rate: about 2%

55 Transparency, Credibility and Accountability The Bank of Korea also introduced various measures to enhance the transparency, credibility and accountability of monetary policy: First, every year the Bank of Korea sets a price stability target for the following year in consultation with the Government before the end of the year, and formulates and promulgates an operation plan for monetary and credit policies including this price stability within 15 days after the setting of the price stability target.

56 Second, every month the Bank of Korea officially announces the Direction of Monthly Monetary Policy immediately after the Monetary Policy Committee of the Bank decides it and the Governor explains its details in a press interview. Third, the Bank of Korea periodically publishes the minutes of the Monetary Policy Committee meeting three months after the meeting. Fourth, the Bank of Korea submits the Monetary and Credit Policy Report to the National Assembly twice a year, normally in March and October, and the Governor is required to answer the questions of the Parliament on the report

57 Establishment of the Inflation Target for 2000 Over the course of 1999, the Consumer Price Index rose by 0.8 of a percentage point compared to the previous year and remained well below the inflation target of three per cent initially set by the Bank at the beginning of the year. For 2000, consumer price inflation is expected to rise by 2.2 per cent on an annual average basis, while underlying inflation, which strips out the prices of petroleum fractions and agricultural products except cereals from consumer prices, is predicted to rise by 1.8 per cent.

58 Taking into account the economic forecasts, the inflation targets in advanced countries, and the inflation rates that should be aimed for in the future in Korea, the Bank set the mid-point of the inflation target for 2000 as 2.5 per cent with a one percentage point range above or below the mid-point based on the annual average underlying inflation rate.

59 Assessment of the Korean Experiences in Inflation Targeting First, the average rate of inflation since the adoption of the inflation targeting system is much lower than that before it was introduced.

60 Inflation Target and Inflation Rates :9 < /OX /` /F_ c X /Z_/ MF :<< //< : :<<<// : ; _ c] Z_ /F_ ]X Z`_/OX ;999//;7 : : 9 :<<9 :<<: :<<; :<< :<< :<< :<< :<< :<< :<<< ;999 ;99: ;99; ;99

61 In 1998 and 1999, the actual inflation rates even remained far be low the inflation targets Appreciation of the Korean Won Reduced burdens of financial costs owing to improved financial structures, and the easing of interest rates Decline in manpower costs reflecting the improved labor productivity and labor market flexibility. Price competition between retailers Government's restraint in raising charges for public services.

62 In 2000, the economy seems to have returned back to the normal situations. In particular, the effect of sharp appreciation of the Korean Won after the depreciation during the crisis, which had contributed to make the inflation rates remain below the lower bound of the inflation target in 1998 and 1999, has almost absorbed. Accordingly, the inflation rate in 2000 is expected to remain in the band of the inflation target.

63 Second, Korea has been carrying out ongoing financial and corporate restructuring. Accordingly, although the inflation targeting is adopted, the Bank of Korea should take into account financial stability as well as price stability in implementing monetary policies

64 Call Rate and Inflation Rates 9 ; X]]/OX ;9 : :9 `c F_ ]X Z`_ F_ ]X Z`_/OX 9 :<< 9: :<< 9 :<< 9: :<< 9 :<< 9: :<< 9 :<< 9: :<< 9 :<<<9: :<<<9 ;9999: ;9999 6

65 Call Rate and the Stock Index :5;99 9 :5999 ` \/F_ X]]/OX ; 99 ;9 99 : 99 :9 ;99 9 <; < < < < < < << ;999 9

66 Third, the low interest rate policy -> a boom in the stock market -> an inflow of capital into the Korean market -> appreciation of Korean Won-> deterioration of the current account Accordingly it seems difficult for a small open economy as Korea to carry out monetary policy focusing only price stability regardless of its current account situation and financial market stability, although it adopts the inflation targeting system. In other words, the problem of the impossibility of the holy trinity may take place.

67 Call Rate, Exchange Rate and the Current Account ^Z]]Z`_/ 7 / X]]`c5/S cc _ /D ` _ ;5 99 X]]/OX X /OX ; :5 99 : :5 99 <; < < < < < < << ; : 6; 6;

68 Conclusion How Much Satisfy Necessary Conditions for IT Central Bank Independence Capacity of Inflation Forecasting Controllability of the Central Bank over Operating Targets Effective Channel of Interest Rates on Prices Transparency, Consistency and Credibility of Monetary Policy

69 Whether and how the central bank of a small open economy, in particular, under financial restructuring, can conduct monetary policy to achieve the final objective of price stability in harmony with maintaining its financial stability and the current account.