Download (2) IT IN TRANSITION TO LOW INFLATION

On Inflation Targeting:
Celebrating 1 Year of IT in Brazil
Klaus Schmidt-Hebbel
Central Bank of Chile
Conference on “One Year of Inflation Targeting in Brazil”
Rio de Janeiro, July 10-11, 2000
Outline
(1) WHO DOES IT?
(2) IT IN TRANSITION TO LOW INFLATION
(3) HOW SUCCESSFUL HAS BEEN IT ?
(4) REMAINING OPEN ISSUES ABOUT IT
(5) CONCLUDING REMARKS
(6) REFERENCES
(1) WHO DOES IT?
Inflation
Initial Inflation and Year of Adoption of Inflation Target in
Industrial and Emerging Economies
25%
Chile
21%
20%
Hungary
18.5%
Israel
18%
15%
Brazil
9.6%
10%
New
Zealand
7.5%
Canada
5%
5%
United
Kingdom
2.6%
Australia
1.8%
Sweden
1.8%
1992
1993
Czech
Republic
10%
Poland
8.5%
1998
1999
Spain
4.3%
0%
1990
1991
1994
1995
1996
1997
2000
IT Countries and Year of Adoption
1990
New Zealand
Chile
1991
Canada
1992
Israel
United Kingdom
1993
Australia
Sweden
Finland
Spain
1994
1998
Hungary
Czech Republic
1999
Poland
Brazil
2000
South Africa
Source: Schaechter, Stone and Zelmer (2000)
Some countries with partial IT regime:
Colombia
Mexico
Peru
Some countries currently considering adoption of IT:
Japan
 Thailand
Turkey
(2) IT IN TRANSITION TO LOW INFLATION
Chileanand
12-month
Inflation
and(Smoothened)
Inflation Targetin
(Smoothened)
Inflation
Inflation
Targets
Chile
35%
Cumulative
Jan.
May
Cumulative
Jan 19911999-Sep
1999
2000 Relative (Absolute)
Relative (Absolute) Deviation
Deviation from Targets:
from Targets: 0.1% (2.2%)
1.9%(3.9%)
30%
25%
20%
15%
10%
05%
00%
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
Actual Inflation, Targets
and Inflation Expectations in Israel
% Annually
25
Cumulative Relative
(Absolute) Deviation
from Targets:
2.4% (13.1%)
Inflation targeting regime
20
CPI change,
year over year
15
1992
Target
10
5
1998
Target
1993
Target
Inflation
expectations
1994
Target
1995
Target
1996
Target
1997
Target
1999
Target
0
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
Indicates December of each year.
Note: Inflation expectation are derived from capital market data on indexed and nonindexed bonds.
Source: Leiderman and Bar-Or (1999)
2000-01
Target
2000
Inflation and Inflation Targets in Brazil (1995-2001)
30%
25%
20%
15%
10%
5%
0%
1995
1996
1997
1998
1999
2000
2001
2002
Some Lessons from 1 Year of IT in Brazil
 Brazil adopted IT under the most unfavorable initial conditions
observed in any IT experience in the world - with outstanding
results regarding inflation, growth, and external position
 Adopting IT with most bells and whistles in place has paid off
handsomely
 Brazil confirms the paramount importance of correcting fiscal
fundamentals and improving health of the banking system for IT
to succeed - future persistence in both dimensions is needed
 Brazil also shows that flexible exchange rates in open
economies with low inflation exhibit small devaluation-toinflation passthrough (confirming Goldfajn and Werlang 2000)
 However Brazil’s experience also reflects the special tensions
and issues confronted by ITers in transition to low inflation
Issues of IT in Transition to Low Inflation (I)
IT in transition to low inflation is very different from IT in
steady-state inflation:
Policy credibility is initially low – it is built up only by showing a
good track record
Short (annual) target horizon makes it hard to achieve targets
Hence there is a bias toward overreacting to adverse shocks and
to temporary shocks  inflation hawkishness and policy
asymmetry
Ironically, the latter is needed to (over-) achieve targets in order
to establish credibility
Issues of IT in Transition to Low Inflation (II)
Speed of adjustment (convergence period) to stationary inflation
is dependent on credibility, inflation indexation mechanisms,
inertia.
However, the decade-long Chilean and Israeli experiences of
transition to low stationary inflation (and possibly the shorter
Brazilian experience) suggest that the convergence period was
excessively long, as ex post sacrifice ratios were likely lower than
anticipated ex ante.
(3) HOW SUCCESFUL HAS BEEN IT?
Evidence from OECD Economies (Bernanke, Laubach,
Mishkin, and Posen):
1. Does IT make disinflation less costly?
No: sacrifice ratios and Phillips curves are not altered by IT
2. Does IT reduce inflation expectations?
Not quickly, only gradually over time (consistent with 1)
3. Does IT reduce inflation?
Yes: IT delivers lower long-run inflation than what would
have been achieved in its absence. But IT is not a necessary
condition for low long-term inflation.
Evidence from OECD and emerging economies
(Cecchetti and Ehrmann)
Model: determines central bankers’ aversion to inflation
variability from the sacrifice ratio (calculated from VAR
impulse responses) and inflation and output variability
Full sample results for the inflation aversion coefficient ():
Average  for the sample of 9 ITers (including Chile and Israel)
is 0.71-0.76, very close to:
Average  of control group of 14 non-ITers (including 2
emerging) is 0.73-0.74
But: the ’s of ITers increase substantially either before or
after starting IT (see figure)
(4) REMAINING OPEN ISSUES ABOUT IT
Design Issues
Operational (or instrument) independence alone? Yes, but ...
Which level of long-run inflation objective? Squeezed between
Friedman, Keynes, and Harrod-Balassa-Samuelson ....
Point or Range Targets? No point will be met but any range is still
too narrow ...
Targeting headline or core inflation? Credibility vs. relevance ...
Strict or relaxed accountability of Central Bank performance?
Transparency, rules and discretion ...
Is IT with all bells and whistles a necessary or just a desirable
prerequisite when starting IT? A lesson from Brazil ...
Research Issues
 Observational equivalence between an explicit IT framework
(say the UK) and other non-explicit monetary frameworks (say
the U.S. or the Bundesbank before the Euro) or mixed regimes
(Euroland)
 Asymmetries and lags in inflationary effects of both shocks
and monetary policy actions are not known with precision
 Lack of agreement of optimal policy response to various
types of shocks (nominal-real.financial, supply-demand,
“permanent-transitory” - their difference not known ex ante)
 Lack of understanding monetary transmission mechanisms
and their empirical relevance is widespread
Monetary Transmission and Policy Rule
in Open Economies
Monetary
Policy
Rule
Inflation
Expectations
Monetary
Policy
Rate
Market Rates
/Term Structure
Output Gap,
Employment
Monetary/Credit
Aggregates
AbsorptionIncome Gap (CA)
Asset Prices
(Wealth)
Nominal
Exchange Rate
Real
Exchange Rate
Projection of
Core-Target
Inflation Gap
Core
Inflation
T Inflation
NT Inflation
Model Development and Use
A necessary, continuous, and costly process  requires significant
research capabilities
Chile’s case: current development of toolkit comprised by various
(small) models used in explaining, forecasting, and simulating. They
comprise:
Leading indicators of prices and activity
Small semi-structural VAR models (4 to 7 variables)
Flow-stock consistency model
Small backward-looking macro model for key relations and
variables (inflation, Phillips curve, activity, absorption (or current
account), potential output, imperfect interest parity, yield curve)
Micro-founded forward-looking rational expectations model for key
relations and variables
Model development and use has been a learning process in
emerging economies, at variable speed depending on needs and
capabilities.
Conduct of Monetary Policy (I)
(problems also apply to other monetary frameworks)
 Large gaps in above mentioned theoretical and empirical
knowledge
 monetary policy is conducted under high level of model
and parameter uncertainty
 Hence: is it feasible to forecast IT with a simple model?
Yes, but development of a menu of increasingly complex
models raises understanding and the level of policy
discussion
Conduct of Monetary Policy (II)
Which weight should be attached to current variables (say inflation)
as compared to predicted future variables?
Answer often leads to symmetrical policy inertia
Which is the optimal speed and intensity of policy reaction to a given
shock?
Depends on various factors, including: uncertainty about
shock feature, weight of arguments in objective function,
degree of central bank aversion to frequent policy
adjustments.
Conduct of Monetary Policy (III)
Which arguments should be included in the monetary policy rule?
1. Inflation deviations only (”inflation nutter”)
2. Inflation deviations plus output deviations (simple Taylor rule;
possibly a majority of economists), but with a large weight attached to
the former (“inflation hawks”)
3. Inflation deviations plus output deviations plus exchange rate
deviations (ECB?) or current-account deviations (some emerging
economies CBs)
4. Inflation deviations plus output deviations plus asset price
deviations:
No: Bernanke and Woodford (1999)
Yes: Cecchetti et al. (2000)
(5) CONCLUDING REMARKS
1. IT - combined with exchange-rate floating - seems to be the main
alternative to dollarization or monetary union
2. IT in transition is very different and, typically, more difficult than
IT in steady-state low inflation
3. Brazil’s IT experience is the boldest experience of adopting IT and,
most likely, the world’s most successful one when controlling for initial
conditions
4. Yet a large number of issues on IT design and performance, and on
the conduct of monetary policy under IT, have to be addressed to
better understanding IT in the world, including:
the fine print on IT design and operation,
opening up the the black box of monetary transmission, and
deriving and defining more transparently an optimal policy
rule.
References
Bernanke, B.S., T. Laubach, F.S. Mishkin, and A.S. Posen: Inflation Targeting: Lessons from the International
Experience. Princeton University Press, 1999.
Bank of International Settlements: “Monetary Policy Operating Procedures in Emerging
Market Economies”, BIS Policy Papers No. 5, March 1999.
Bank of International Settlements: “The Transmission of Monetary Policy in Emerging Market Economies”, BIS Policy
Papers No. 3, January 1998.
Cecchetti, S. G. And M. Ehrmann: “Does inflation targeting increase output variability? An International Comparison
of Policymakers’ Preferences and Outcomes”, presented at the Third Annual Conference of the Central Bank of Chile,
Santiago, Sep. 20-21, 1999.
Cecchetti, S.,H. Genberg, J. Lipsky and S. Wadhawani: “Asset prices and Central Bank Policy”, Geneva Reports on the
World Economy 2, July 2000.
Corbo, V. “Monetary Policy in Latin America in the 1990s”, presented at the Third Annual Conference of the Central
Bank of Chile, Santiago, Sep. 20-21, 1999.
Debelle, G. (1999): “Inflation Targeting and Output Stabilisation”, Research Bank of Australia Research Discussion
Paper 1999-08, June 1999.
Debelle, G., Masson, P. , M. Savastano, and S. Sharma: “Inflation Targeting as a Framework for Monetary Policy”,
Economic Issues 15, IMF, 1998.
Fischer, S.: “Maintaining Price Stability”, Finance and Development 33(4): 34-37, Dec. 1996.
Fry, M., Julius, D., Mahadeva, L., Roger, S., and G. Sterne: “Monetray Policy Frameworks in a Global Context”,
manuscript, Centre for Central Banking Studies, Bank of England, June 1999.
Goldfajn, I. and S. Werlang: “The Pass-through from Depreciation to Inflation: A Panel Study”, Catholic University of
Rio Working Paper 423, 2000.
Landerretche, O., F. Morandé, and K. Schmidt-Hebbel: “Inflation Targets and Stabilization in Chile”, in L. Mahadeva
and G. Sterne (editors): Monetary Policy Frameworks in a Global Context, Routledge, London, May 2000.
Leiderman, L. and H. Bar-Or: “Monetary Policy Rules and Transmission Mechanism under Inflation Targeting in
Israel”, presented at the Third Annual Conference of the Central Bank of Chile, Santiago, Sep. 20-21, 1999.
Lowe, P. (ed.): “Monetray Policy and Inflation Targeting (Proceedings of a Conference)”, Economic Group, Reserve
Bank of Australia, 1997.
Masson, P. A., M. A. Savastano, and S. Sharma: “The Scope for Inflation Targeting in Developing Countries”, IMF
Working Paper WP/97/130, Oct. 1997.
Restrepo, J. “Monetary Rules in Colombia and Chile”, manuscript, Departamento Nacional de Planeación de Colombia,
May 1999.
Sterne, G. “The Use of Explicit Targets for Monetary Policy”, Bank of England Quarterly Bulletin 272-81, Aug. 1991.
Outline
(1) WHO DOES IT?
1.
2.
3.
4.
Explicit targets in the 1990s (Sterne)
Initial inflation and year of adoption of IT in industrial and emerging economies
Year of Adoption of IT in industrial and emerging economies
Countries with partial IT regime and countries considering adoption of IT
(2) IT IN TRANSITION TO LOW INFLATION
5. Inflation and inflation target in Chile
6. Inflation and inflation target in Israel
7. Inflation and inflation target in Brazil
8. Some Lessons from 1 Year of IT in Brazil
9. Issues of IT in Transition to Low Inflation (I)
10. Issues of IT in Transition to Low Inflation (II)
(3) HOW SUCCESFUL HAS BEEN IT?
11.Evidence from OECD countries (Bernanke, Laubach, Mishkin, and Posen)
12. Evidence from OECD countries and emerging economies (Cecchetti and Ehrmann)
13. Estimates of Inflation Variability Aversion in IT countries (Cechetti and Ehrmann)
(4) REMAINING OPEN ISSUES ABOUT IT
14.Design Issues
15.Research Issues
16. Monetary Transmission and Policy Rules in Open Economies
17. Model Development and Use
18. Conduct of Monetary Policy (I)
19. Conduct of Monetary Policy (II)
20. Conduct of Monetary Policy (III)
(5) CONCLUDING REMARKS
(6) REFERENCES