Monetary Policy Bank Indonesia International Workshop and Seminar Central Bank Policy Mix: Issues, Challenges and Policies Jakarta, 9-13 April 2018 Stephan Danninger The views expressed herein are those of the author and should not be attributed to the IMF, its Executive Board, or its management.
Inflation and Monetary Policy Among key goals of economic policymakers are low inflation and low unemployment sometimes goals conflict In the short run, if policymakers try to expand aggregate demand (using monetary or fiscal policy) they will tend to increase output (decrease unemployment) and raise the inflation rate Ability to assess inflation and monetary policy stance are, therefore, critical in limiting potential conflicts between the two key macroeconomic policy objectives 2
Lecture Outline Inflation and Its Determinants Monetary policy, regimes, and transmission Assessing the stance of monetary policy o o o o Inflation expectations approach Real interest rate approach Taylor Rule approach Yield Curve approach 3
I. Inflation and Its Determinants 4
What is Inflation? Definition Inflation is the rise in the general level of prices of goods and services in an economy over a period of time When positive inflation When negative deflation Consumer Price Index (CPI) Headline CPI Inflation Alternative CPI measures (e.g. core inflation) 5
What is the Difference Between Headline and Core Inflation? Headline inflation is the total movement of prices Core inflation is supposed to be the long-run, less volatile, component of CPI Core inflation reflects general inflationary pressures in the economy it excludes some components Energy Food Regulated prices No firm theoretical basis; no generally agreed approach to measuring core inflation 6
CPI Weights: United States 7
CPI Weights: Cambodia 2.9 1.2 5.9 2.3 Food & Non Alcoholic Beverage Alcoholic Beverage, Tobacco & Narcotics 1.1 Clothing & Footwear Housing & Utilities 2.7 12.2 5.1 44.8 Furnishing & Household Maintenance Health Transportation Communication Recreation & Culture Source: CEIC Data Co. 17.1 3.0 1.6 Education Restaurants Miscellaneous Goods & Services 8
Core Inflation: Permanent Exclusions Depends on the purpose Forecasting accuracy Tax changes Regulated Energy Food Decision making Tax changes yes Energy prices questionable Food prices highly questionable Typically a large part of the basket Huge spillovers to the rest 9
Core Inflation: Country Examples Country Malaysia Canada Official Core Measure CPI excluding Food and Energy CPI excluding Food, Energy and Indirect Taxes Thailand CPI excluding Fresh Food and Energy (23%) Chile New Zealand (90s) Singapore Japan Peru United States United Kingdom CPI excluding 20% with higher (-) variations and 8% with higher (+) variations CPI excluding interest charges CPI excluding costs of private road transport and costs of accommodation CPI excluding Fresh Food CPI excluding 9 volatile items (food, fruits and vegetables, and urban transport, about 21.2 %) CPI excluding food and energy Retail price index excluding mortgage interest rates (RPIX) 10
Contributions to CPI Thailand: Contributions to CPI 10.0 8.0 6.0 4.0 2.0 0.0-2.0-4.0-6.0-8.0 Transport & Communication (TC) Food & Beverages (FB) Clothing & Footwears (CF) Housing & Furnishing (HF) Health & Personal Care (HP) Recreation, Reading, Education and Religion (RR) Tobacco & Alcoholic Beverages (TA) Thai CPI (% change OYA) 11
Comparing Headline and Core CPI Inflation Malaysia: Headline vs. Inflation Excluding Food and Energy 9.0 6.0 3.0 0.0-3.0 Headline Inflation CPI excluding Food and Energy (YoY) -6.0 Jan-2006 Jan-2007 Jan-2008 Jan-2009 Jan-2010 Jan-2011 Jan-2012 Jan-2013 Jan-2014 Jan-2015 Jan-2016 Jan-2017 Source: Haver Analytics 12
Long-run Determinants of Inflation Inflation is always and everywhere a monetary phenomenon ~ M. Friedman Quantity theory is the general theory of inflation MV P = Y m+ v = π + y π = m+ v y where M:money, P:prices, Y:output, V:velocity Constant velocity and money neutrality -> inflation follows money growth In the long run, periods of hyperinflation Less so in the short run in normal times
Short-run Inflation: Why Care? Important to understand what determines inflation in short-run Even temporary shock could ignite inflation spiral Example: oil price -> cost of production -> prices of goods -> demand for higher wages -> labor cost Also through inflationary expectations 14
What are Possible Short-run Determinants of Inflation? Past inflation (hysteresis) Expectations Domestic demand and supply pressures Business cycle factors (Phillips curve) Market structure Indirect taxes External spillovers Import prices Commodity prices Exchange rate movements 15
Phillips Curve E π = απ + δ y y + ε ( ) t t t Expected Inflation (π E ) Deviations of unemployment from the natural rate or the output gap - demand shocks ( ) Other shocks, in particular supply shocks (ε t ) y t y 16
Augmented New-Keynesian Phillips curve Change in real marginal cost ( ) e t = t 1 + 1 t+ 1 + rmct + t π απ α π β ε Prices are set via both backward and forward looking expectation E.g. a subset of firms set prices according to a backward-looking rule of thumb (contracts, wages) Transmission mechanism in real marginal cost (rmc) Demand rises Firms respond and produce more (no shortage on the market) However, firms face increasing marginal costs Firms must ask for higher price 17
Components of Real Marginal Costs Real marginal cost (rmc) can be approximated as a function of: Domestic producers - Output gap, unemployment gap - Real wage gap if real wages are counter-cyclical Importers - Real exchange rate gap - Or import prices gap 18
II. Monetary Policy and Transmission 19
Countries need to choose: Compatible choices A monetary policy strategy (e.g. inflation targets or money growth targets) An exchange rate arrangement Type of management of international capital flows The choices must be compatible! 20
Trilemma (Mundell, 1963) Capital Mobility Interest rate parity Inflation Target Monetary Target TRILEMMA Fixed exchange rates: Monetary union, Currency board Monetary Autonomy Fixed exchange rates with capital controls Exchange Rate Stability 21
Two Important Issues As one evaluates monetary policy, two important issues must be kept in mind: Issue #1: What is the monetary policy regime what is the central bank saying and what is it actually doing? Issue # 2: What is the transmission mechanism of monetary policy? 22
Issue #1: The Monetary Policy Regime The policy regime is the framework used by the monetary authorities to influence the evolution of macro variables The nominal anchor is the publicly-announced variable that serves as the long-run target for monetary policy Instruments are the facilities that central banks employ to achieve the target(s) Commitment to the framework is important to building credibility (making the CB accountable to achieving stability helps anchor inflation expectations) Effective communication strategy is essential 23
Possible Monetary Policy Regimes 24
Monetary Policy Regimes around the World 25
Issue #2: The Transmission Process Interest Rates Monetary Aggregates Exchange Rate Asset Prices Real GDP Price Level 26
Monetary Transmission Mechanism (MTM) Understanding the MTM is essential for monetary policy design and calibration. To determine the nature of the transmission mechanism in a specific country requires: Monitoring the response of key variables / markets Modeling the dynamics and identifying time lags Gauging the projected quantitative response to Monetary Policy decisions 27
MTM: Inflation Expectations Channel CPI inflation Monetary Policy Framework Domestically- Generated ππ Inflation expectations
MTM: Interest Rate Channel Monetary Policy Framework Central Bank Policy Rate Bank lending rates and credit conditions loans Corporate demand Domestically- Generated ππ CPI inflation deposits Household demand Inflation expectations
MTM: Exchange Rate Channel Exchange rate Import prices Net external demand Monetary Policy Framework Central Bank Policy Rate Bank lending rates and credit conditions loans Corporate demand Domestically- Generated ππ CPI inflation deposits Household demand Inflation expectations
MTM: Asset Price Channel Term structure, asset prices and capital market conditions Exchange rate Net external demand Import prices Monetary Policy Framework Central Bank Policy Rate Bank lending rates and credit conditions loans Corporate demand Domestically- Generated ππ CPI inflation deposits Household demand Inflation expectations
MTM: Quantitative Easing Asset purchase/ sales (QE) Term structure, asset prices and capital market conditions Exchange rate Net external demand Import prices Monetary Policy Framework Central Bank Policy Rate Bank lending rates and credit conditions loans Corporate demand Domestically- Generated ππ CPI inflation deposits Household demand Inflation expectations
Macroprudential Policy Asset purchase/ sales (QE) Term structure, asset prices and capital market conditions Exchange rate Net external demand Import prices Monetary Policy Framework Central Bank Policy Rate Bank lending rates and credit conditions loans Corporate demand Domestically- Generated ππ CPI inflation Macro prudential policy deposits Household demand Inflation expectations
MTM: The Role of Communications Asset purchase/ sales (QE) Term structure, asset prices and capital market conditions Exchange rate Net external demand Import prices Monetary Policy Framework Central Bank Policy Rate Bank lending rates and credit conditions loans Corporate demand Domestically- Generated ππ CPI inflation Central Bank Communication Macro prudential policy deposits Inflation expectations Household demand
III. Assessing the Stance of Monetary Policy 35
Inflation Expectations Approach Expected inflation may be: Estimated from surveys of market participants, households and firms Inferred from interest rates on otherwise similar inflationindexed (and non-indexed) bonds; i.e. market-based instruments 36
Inflation Expectations Approach Inflation expectations are said to be well anchored if they approach the central bank inflation π T over some horizon I E t π t+i -> π T Horizon: 2 to 10 years but varies by country Implicit assumptions: o Commitment to an inflation target o Target known to the public o Central bank uses policy levers to move inflation towards its target, thus managing inflation expectations o Expected inflation is the only basis for assessment of the stance of policy 37
Inflation Expectations Approach The following conditions suggest that monetary policy is o Neutral if E t π t+i = π T o Tight or not sufficiently loose if E t π t+i < π T o Loose or not sufficiently tight if E t π t+i > π T 38
Are Inflation Expectations Well Anchored in Advanced Economies? * * E t π t + i π = α + β ( πt π ) Under the H 0 of well anchored expectations : α=β=0 + ε t Intercept falling to zero Slope falling to zero Source: WEO (2013), The Dog that Didn t Bark: Has Inflation Been Muzzled or Was it Just Sleeping, April, chapter 3.
U.S. Inflation Expectations Comparing Indexed and Non-Indexed Securities U.S. Inflation Expectations 6.0% 10Y Treasury Inflation-Indexed Security, Constant Maturity 10Y Treasury, Constant Maturity 4.0% 2.0% 0.0% -2.0% Source: Bloomberg
Korea: Inflation Expectations Source: Consumer Survey Index Inflation Expectations, Bank of Korea
Real Interest Rate Approach Fisher equation = + π e + t t t t + 1 t i r E rp Nominal interest rate Real interest rate Expected inflation Risk premia Note problems in measuring r t Expected inflation is unobserved Risk premia is unobserved Nevertheless the real interest rate may be used to evaluate the stance of monetary policy 42
Was Monetary Policy in Korea Tight in 2007? Real Central Bank Overnight Policy Rate 14 12 10 8 6 4 2 0 Q4- -2 2000 Q4-2002 Q4-2004 Q4-2006 Q4-2008 Q4-2010 Q4-2012 Q4-2014 Q4-2016 How can we make this assessment using the information we have about the real interest rate? Real Central Bank Policy Rate SSource: Haver Analytics; Bloomberg 43
Measuring the Real Interest Rate Gap in Korea 14 12 10 8 6 4 Real Central Bank Overnight Policy Rate Estimate a long-run equilibrium value for the real interest rate. An example: the trend of real interest rate. Deviations from the trend, or gaps can signal the stance of policy: 2 0 Q4- -2 2000 Q4-2002 Q4-2004 Q4-2006 Q4-2008 Q4-2010 Q4-2012 Q4-2014 Q4-2016 r - r > 0 policy tight r - r < 0 policy loose Real Central Bank Policy Rate Neutral Real Interest Rate (r*) SSource: Haver Analytics; Bloomberg 44
The Taylor Rule Taylor (1993) defines interest rate rule relating fed funds rate with steady state real interest rate and inflation gap and output gap. General form: Inflation i t = r + π + c ( π π ) + c ŷ + t 1 t 2 t ε t Central bank or shortterm money market interest rate Short-term trend real interest rate Explicit or implicit definition of price stability Output gap 45
The Taylor Rule Taylor s original estimation: i t = 2 + π + 0.5( π 2) + t t 0.5yˆ t Forward-looking version Coefficient must be higher than zero Taylor principle i t = i + f π + π ) + f yˆ + ε n t e 1( t 1 2 t t n e it = r + π t+ 1 Where is called a policy neutral rate And where f1 = 1.5, f2 = 0.5 46
Inflation Targeting Rule A version of the forward-looking Taylor rule without the output gap : i t n t e 1 ( t 1 = i + f π π ) + ε + = + π n e i r 1 Where t t+ is the policy neutral rate t Not very realistic; even the inflation targeting central banks care to some extent about the output gap 47
Stance of Monetary Policy To assess the stance of current policy using a Taylor rule one compares actual rate with derived Taylor rate: If i current - i tr < 0 then monetary policy was too loose If i current - i tr > 0 then monetary policy was too tight Where i tr is interest rate derived from Taylor rule To assess the stance of current policy using inflation targeting rule one compares actual rate with derived rate: If i current - i itg < 0 then monetary policy was too loose If i current - i itg > 0 then monetary policy was too tight Where i itg is interest rate derived from inflation targeting rule 48
A Timing Issue Taylor Rule looks easy and is a good starting point But when assessing the monetary policy stance I. There is the problem of real-time output gap estimation II. III. o Output gap estimation may be imprecise Same applies for the trend real interest rate But mainly, reaction to the observed inflation leaves you behind the curve one reacts too late Hence a forecast for inflation is needed Use financial market expectations with caution influenced by and in turn influence the stance of monetary policy 49
Taylor Rule in Pre-Crisis Fed Policy Easy monetary policy in 2001-2005 Actual interest rate (federal funds rate) below that implied by the Taylor rule Summarized in THE FINANCIAL CRISIS AND THE POLICY RESPONSES AN EMPIRICAL ANALYSIS OF WHAT WENT WRONG NBER Working Paper 14631 SSource: The Economist, http://www.economist.com/node/9972453 50
Bernanke s Response Source: Ben Bernanke: Monetary Policy and the Housing Bubble ", At the Annual Meeting of the American Economic Association, Atlanta, Georgia, January 3, 2010. 51
Yield Curve and Pure Expectations A yield curve may be used as a leading indicator of economic conditions In order to interpret the yield curve, we need a theory of how interest rates for various maturities are determined The simplest theory is the expectations theory which holds that the slope of the yield curve reflects only investors' expectations for future short-term interest rates. The pure expectations theory predicts that yields on various maturities move together. the yield curve is slightly upwardly sloped. 52
Yield Curve and Risk Premium Recall the Fisher equation i = r + E + rp π e t t t t + 1 t The risk premium compensates the bond holder for risks associated with unexpected inflation (inflation risk premium) and risks associated with holding a longer-term asset (term premium) Changes in the yield curve reflect changes in Risk (term) premium Expected inflation Expected monetary policy Correlated with first two factors 53
Interpreting an Upward Sloping Yield Curve A steep upward sloping yield curve could mean any of the following: The risk premium is larger in period 2 Monetary policy is relatively loose in period 1 Inflation is expected to be higher in period 2 How the (slope of) yield curve changes over time is important in assessing the stance of policy 54
Malaysia 5.5 Government Bond Yield Curves 2007-2016 (Q4 Average % p.a) 5.0 4.5 Dec-07 Dec-09 Dec-11 Dec-13 Dec-15 Sep-17 4.4 4.7 5.0 4.9 Yield (% p.a) 4.0 3.5 3.0 2.5 Dec-09 2.0 1.5 3-Months Maturity 6-Months Maturity 1-Year Maturity 3-Year Maturity 5-year Maturity 7-year Maturity 10-year Maturity 15-year Maturity 20-year Maturity 30-year Maturity 55
Key Takeaways Understanding inflation is complicated Understanding the MTM is key to the design and calibration of monetary policy To analyze the stance of monetary policy there are different diagnostic tools Inflation Expectation Approach Real Interest Rate Approach Taylor Rule and Inflation Targeting Rule Yield Curve Each tool has pros and cons 56
Thank you! 57
Appendix 58
Inflation Expectations Help stabilize inflation, but can also destabilize it Even temporary shocks can have long-lasting effects on inflation Are determined by: Credibility of monetary and fiscal policy (ππ tt ee = ππ TT ) Recent inflation (ππ tt ee = ππ tt 1 ) adaptive expectations Long-run trend/ natural level of inflation Are not observable Surveys Households, business, official forecasters and market analysts Financial data 59
Malaysia: Inflation Expectations 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% -2.0% -4.0% Expected Inflation (One-year ahead) CPI Inflation, %y/y Source: Haver Analytics, IMF WEO Outlook Source: Consumer Survey Index Inflation Expectations, Bank of Korea