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Open-Economy Inflation Targeting Tomáš Holub International Macroeconomics May 2015 Outline • MP regimes – some traditional alternatives • Inflation targeting in theory • Performance of inflation targeting • Inflation targeting and the recent crisis • Summary and conclusions Some Alternatives of MP Regimes (with Floating ER) Money targeting Infl. targeting Two pillars Just do it OMOs Repo rate Refi rate Fed funds Monetary base Money market rates Money market rates Money market rates Money supply (target) Monetary transmission Inflation (goal) Inflation (goal+target) Econ. outlook Money supply Inflation (goal) Monetary transmission Inflation, growth etc. (goals) Monetary Policy Regimes (i) Source: IMF; Batini, et al. (2006) • Exchange rate pegs and multiple targets still quite numerous, but IT gaining increasing share. Monetary Policy Regimes (ii) Share of alternative MP regimes in the world (IMF de facto, sample of 125 countries) 100% 90% euro area 80% 70% pegged exchange rate 60% 50% other 40% 30% 20% 10% money targeting / IMF program (often with elements of M-targeting) Inflation targeting 0% 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 • IT‘s share above 20% (around 32 countries now; i.e. still a minority in practice, but state-of-the art in theory before the crisis). Monetary Policy Regimes (iii) • Inflation targeting + ECB‘s 2-pillar strategy dominate for freely floating countries. • But IT also most frequent for (managed) floating countries. Monetary Policy Regimes (iv) Inflation targeting: Money targeting: Georgia, Dominican Rep., Indonesia, Paraguay, Albania, Armenia, Brazil, Colombia, Ghana, Guatemala, Hungary, Iceland, South Korea, Mexico Moldova, New Zealand, Peru, Philippines, Romania, Serbia, South Africa, Thailand, Turkey, Uruguay, Australia, Canada, Chile, Czech Rep., Israel, Japan, Mexico, Norway, Poland, Sweden, UK Congo, Tajikistan, Ukraine, Yemen, Argentina, China, Rwanda, Uzbekistan, Bangladesh, Burundi, Guinea, Kyrgyz Rep., Malawi, Nigeria, Afghanistan, The Gambia, Kenya, Madagascar, Mozambique, Papua New Guinea, Seychelles, Sierra Leone, Sri Lanka, Tanzania, Uganda, Zambia Advantages of Inflation Targeting • Embodies all the modern trend in central banking: independence, rules, transparency and accountability; • Combines a policy rule with discretion (flexible rule); • The target and the ultimate goal are identical; • Does not rely on stable money demand; • Takes into account all available information; • A direct emphasis put on market expectations; • Strengthens internal discipline and forecasting of CB. Theoretical Background Inflation var(inflation) F S Unemployment var(output) • Trying to reach both low inflation (primary goal – can be controlled by MP in the long run) and optimal stabilisation in the presence of (often unforeseen) shocks. Closed-Economy Inflation Targeting Phillips Curve t 1 Et t 1 1 yt 2 xt t 1 Et t 1 t Aggregate Demand yt 1 1 yt 2 it Et t 1 3 xt t 1 Loss Function MinE t s t s t t ; strict t 2 [ t t ] ; Policy rule flex t 2 [ t t ] y Et t 2 ; Et t 2 c Et t 1 * * 2 t * Policy Rule under Inflation Targeting Strict Inflation Targeting: equate the forecast of inflation with your target at the horizon of transmission (Svensson: “inflation-forecast targeting”). Current inflation forecast actual (1) target actual (2) 0 1 change in IR change in AD, GDP, employment 2 change in inflation • Beware: no one actually does strict inflation targeting! Policy Rule under Inflation Targeting Flexible Inflation Targeting: gradually return the forecast of inflation to target, taking into account the variability of output. Current inflation forecast actual (1) target actual (2) 0 1 change IR change in AD, GDP, uneployment 2 change in inflation • In practice: setting the monetary policy horizon, choice of targeted index, escape clauses, IR smoothing, etc. Open-Economy Inflation Targeting Phillips Curve D F tD1 Et tD1 1 yt 2 xt 3qt t 1; tCPI 1 1 t 1 t 1 Aggregate Demand D * yt 1 1 yt 2 it Et t 1 3 xt 4 qt 5 yt t 1 Exchange Rate * it it st 1 st t MCI t 2 it Et D t 1 4 Loss Function CPI t [ CPI t 2 t ] 2 vs. [ t ] D t D t qt UIP and the MP Transmission Exchange rate ( = appreciation) unexpected IR increase time • An unexpected domestic IR increase should lead to a jump appreciation, which creates expectations of future depreciation. • In practice, the adjustment is often more gradual. Exchange Rate Transmission • A richer set of transmission channels with different speeds. 0 change in IR+ER prices of imported goods change in inflation 0 1 change in IR+ER prices of imported inputs 0 change in IR+ER change in inflation 1 change in AD, GDP, employment 2 change in inflation • The exchange rate may also be a source of shocks. Performance of IT before the crisis … the lessons to draw from the empirical evidence are what might be described as “non-negative”. The contribution of inflation targeting to low and stable inflation among industrial countries is weak, but it also has not had negative effects on real activity. It does seem to have anchored inflation expectations. For the developing economies, inflation targeting has been associated with lower and more stable inflation and real activity. (Walsh, 2009) (for more on this, see the seminar) IT Performance in the Crisis Rose (2013) • Inflation targeting has proven quite durable – no one has left it except for the euro adoption. (ht http://faculty.haas.berkeley.edu/arose/Spill.pdf). IT Performance in the Crisis Rose (2013) • Not much difference between IT and hard pegs (but better inflation performance than the other regimes). • See also Irineu E. de Carvalho Filho (2011) – seminar topic. IT and the Recent Crisis • When IT was being introduced, it was often criticised as too tight („inflation freaks“). • Before the crisis, some people were saying that the IT alone is not enough, and that it might actually be too loose, thus „blowing with the wind“ (e.g. W. White, BIS). • After the crisis broke out, this camp was joined by many others, but: Was it due to IT per se? Or was the MP too loose even by the IT standard (failure of implementation vs. failure of regime)? MP in Major Economies – Deviations from the Taylor Rule 10 9 Euro area - actual rate Euro area - Taylor rule 8 7 6 5 4 3 2 1 0 I/99 Source: IMF, WEO, April 2009. I/00 I/01 I/02 I/03 I/04 I/05 I/06 I/07 I/08 Source: Eurostat, CNB calculations. • The MP was quite loose even by the traditional (IT) standards. • Response to the dot.com bubble and September 11; too much focus on core inflation, output gap etc.? Deviations from the Taylor Rule and Housing Booms Source: Ahrend, et al. (2008) IT and the Recent Crisis (cont.) • Now some people are actually once again suggesting that IT is too tight, and that central banks need to „commit to irresponsibility“ to overcome the ZLB / deflation threat. • Price level targeting or nominal GDP level targeting have been suggested as alternatives. • No country has actually adopted these regimes yet (just some temporary elements of it within the IT framework). • Japan: has recently increased its inflation target to 2% to overcome deflation. IT vs. Price Level Targeting inflation targeting price-level targeting 110 110 108 108 106 106 104 104 102 102 100 100 6 4 2 0 -2 6 4 2 0 -2 1 2 3 period 4 target price level and inflation after price shock Source: Böhm, et al. (2012) 5 1 2 3 period 4 target price level and inflation after price shock 5 Conclusions • Inflation targeting focused on building credibility and anchoring expectations (”constrained discretion“); • IT has gained bigger ”market share“ among MP regimes; • Strict vs. flexible inflation targeting (no one does the strict one); • In open economies, the exchange rate is an important part of the transmission mechanisms, as well as a source of shocks; • The performance seems to be good (or at least non-negative) so far; • The current crisis has challenged the paradigm, but IT may survive it – with modifications – better than most other known alternatives (and PLT is so far a textbook debate). Thank you for your attention. Some References • • • • • • • • • • • • Benecká, S. (2011): ”International reserves and the financial crisis: monetary policy matters,“ CNB mimeo. Benecká, S., Holub, T., Kadlčáková, N.L., and Kubicová, I. (2012): ” Does Central Bank Financial Strength Matter for Inflation? An Empirical Analysis“ CNB WP (forthcoming). BoC (2011): ”Renewal of the Inflation-Control Target: Background Information - November 2011“, Bank of Canada, http://www.bankofcanada.ca/wp-content/uploads/2011/11/background_nov11.pdf. Böhm, J., Filáček, J., Kubicová, I., and Zamazalová, R.(2012): ”Price-Level Targeting - A Real Alternative to Inflation Targeting?“ Czech Journal of Economics and Finance, vol. 62, no. 1, pp. 2-26, http://journal.fsv.cuni.cz/mag/article/show/id/1237. Gonçalves, C.E.S, and Salles, J.M. (2008): ”Inflation targeting in emerging economies: What do the data say?“ Journal of Development Economics, 85, pp. 312–318, http://www.sciencedirect.com/science/article/pii/S0304387806001283. IMF, Batini et al. (2006): ”Inflation Targeting and the IMF“, http://www.imf.org/external/np/pp/eng/2006/031606.pdf. Irineu E. de Carvalho Filho (2011): ”28 Months Later: How Inflation Targeters Outperformed Their Peers in the Great Recession,” The B.E. Journal of Macroeconomics: Vol. 11: Iss. 1 (Topics), Article 22, http://www.bepress.com/bejm/vol11/iss1/art22. Mishkin, F. S., Schmidt-Hebbel, K. (2006): “Does Inflation Targeting Make a Difference?“ CNB WP, no. 13/2006 http://www.cnb.cz/www.cnb.cz/en/research/research_publications/cnb_wp/2006/cnbwp_2006_13.html. Svensson, L. E. O. (1999a): “Inflation Targeting as a Monetary Policy Rule,” Journal of Monetary Economics, 43, pp. 607–654. Svensson, L. E. O. (1999b): “Price Level Targeting vs. Inflation Targeting: A Free Lunch?” Journal of Money, Credit and Banking, no. 31, pp. 277–295. Svensson, L. E. O. (2000): “Open-Economy Inflation Targeting”. London, CEPR Discussion Paper, no. 1989 (October). Walsh, C.E. (2009): ”Inflation targeting: What have we learned?“ The John Kuszczak Memorial Lecture, prepared for "International Experience with the Conduct of Monetary Policy under Inflation Targeting," Bank of Canada, July 22-23, 2008, http://people.ucsc.edu/~walshc/MyPapers/Kuszczak_Lecture_20090131.pdf.