Download Creeping Inflation: How much of a concern?

Creeping Inflation: How much of
a concern? What should the
response be?
XXVII Meeting of the Latin American Network of Central
Banks and Finance Ministries
Alberto Torres
Banco de México
May 8th, 2008
Outline
1. Real Food and Oil Price Changes
2. Implications for Monetary Policy
3. Additional Considerations
1. Real Food and Oil Price Changes
Commodity Price Indexes
(Index Jan 2003 = 100)
380
440
Non Fuel
Food
Crude Oil
Metals (right axis)
330
390
340
280
290
230
240
180
190
Source: IMF.
Jan-08
Jul-07
Jan-07
Jul-06
Jan-06
Jul-05
Jan-05
Jul-04
90
Jan-04
80
Jul-03
140
Jan-03
130
3
1. Real Food and Oil Price Changes
Real Food Price Changes
(Annual % Change of Real Price)
50
40
Food
Mean per regime
30
20
10
0
-10
-20
-30
Source: IMF. Calculations by Banco de México.
Jan-07
Jan-05
Jan-03
Jan-01
Jan-99
Jan-97
Jan-95
Jan-93
Jan-91
Jan-89
Jan-87
Jan-85
Jan-83
Jan-81
-40
4
1. Real Food and Oil Price Changes
Distribution of Real Food Price Changes
(Annual % Change of Real Price)
40
20
0
-20
Jan.81-Nov.85 Dec.85-Jan.97 Feb.97-Dec.99Jan.00-Aug.02 Sep.02-Mar.08
Source: IMF. Calculations by Banco de México.
5
1. Real Food and Oil Price Changes
Real Food Price Changes
(Proportion of Time Above Threshold)
0.8
Jan. 81 - Nov. 85
Dec. 85 - Jan. 97
Feb. 97 - Dec. 99
Jan. 00 -Aug. 02
Sept. 02 -Mar. 08
0.6
0.5
0.4
0.3
A
0.2
0.1
38
36
34
32
30
28
26
24
22
20
18
14
12
10
8
6
4
2
16
B
0.0
0
Proportion above Threshold .
0.7
Threshold
Source: IMF. Calculations by Banco de México.
6
1. Real Food and Oil Price Changes
Real Food Price Changes
(Mean Above Threshold)
14
Jan. 81 - Nov. 85
Dec. 85 - Jan. 97
Feb. 97 - Dec. 99
Jan. 00 -Aug. 02
Sept. 02 -Mar. 08
12
A
8
6
4
B
2
38
36
34
32
30
28
26
24
22
20
18
16
14
12
10
8
6
4
2
0
0
Conditional mean
10
Threshold
Source: IMF. Calculations by Banco de México.
7
1. Real Food and Oil Price Changes
Real Crude Oil Price Changes
(Annual % Change of Real Price)
200
Crude Oil
150
Mean per regime
100
50
0
-50
Source: IMF. Calculations by Banco de México.
Jan-07
Jan-05
Jan-03
Jan-01
Jan-99
Jan-97
Jan-95
Jan-93
Jan-91
Jan-89
Jan-87
Jan-85
Jan-83
Jan-81
-100
8
1. Real Food and Oil Price Changes
Distribution of Real Crude Oil Price Changes
(Annual % Change of Real Price)
150
100
50
0
-50
Jan.81-Jan.87
Feb.87-Jul.91
Aug.91-Mar.99
Source: IMF. Calculations by Banco de México.
Abr.99-Mar.08
9
1. Real Food and Oil Price Changes
Food
(Annual % Change of Real Price)
Duration
(months)
Regimes
Mean
s.d.
Max.
Period
I
-9.79
8.33
9.30
59
Jan-81 Nov-85
II
-1.74
7.26
18.77
134
Dec-85 Jan-97
III
-12.48
3.82
-5.52
35
Feb-97 Dec-99
IV
-2.58
3.75
5.14
32
Jan-00 Aug-02
V
7.57
10.02
37.96
67
Sep-02 Mar-08
Crude Oil
(Annual % Change of Real Price)
Duration
(months)
Regimes
Mean
s.d.
Max.
Period
I
-16.47
16.29
2.18
73
Jan-81 Jan-87
II
11.12
29.36
91.11
54
Feb-87 Jul-91
III
-8.19
19.03
40.53
92
Aug-91 Mar-99
IV
23.83
33.34
144.75
108
Apr-99 Mar-08
10
Outline
1. Real Food and Oil Price Changes
2. Implications for Monetary Policy
3. Additional Considerations
2. Implications for Monetary Policy

As is well-known in the economic literature (e.g. Clarida, Gali and
Gertler, 1999; Walsh, 2003; Woodford, 2003; and others) the
optimal monetary policy response to any shock is the solution to a
problem where:
 The policy maker minimizes a quadratic loss function that reflects
society’s preferences for inflation and output stabilization.
 This optimization is made subject to the structure of the economy,
which is typically assumed linear (or log-linear).
 In addition, shocks are assumed to follow an AR(1) process with
white noise disturbances.

The solution to this problem provides an optimal feedback rule for
the monetary policy instrument which will be a linear, time-invariant
function of all the variables and shocks that form part of the
economy.
12
2. Implications for Monetary Policy

However, we are not currently in this type of framework:
 For many central banks, high inflation may be more costly than low
inflation.
 The economy seems to behave differently in recessions than in
booms (e.g., Hamilton (1989)).
 The shocks we are currently facing, as shown above, follow a very
complex stochastic process, with regime shifts, time varying
variances and extreme values.
 In addition, there is uncertainty about the duration of the “high
inflation regimes” in commodity prices.

In this context, the optimal response of monetary policy is likely to
be non-linear and time-varying, and will tend to focus on risk
management.
13
2. Implications for Monetary Policy

Following the risk management approach, the response to
this environment should be preemptive, significant and
transparent:
 Failure to act timely may lead to a contamination of the
price-setting process; in particular, may affect the
formation of inflation expectations.
 The response has to be strong, as central banks may
prefer to insure against low probability, costly outcomes.
 The central bank has to clearly explain the rationale for its
policy actions.

But, as we will now see, how preemptive and strong the
response should be, depends on the particular
circumstances of each economy.
14
2. Implications for Monetary Policy
2005 – 2007 Inflation Change and Inflation Persistence
Change in Inflation from 2005 to 2007
4
Uru
Bol
Ven
2
Sin
Pan HK
Par
Col
Chi GerJapPor Ire
Ecu
Mex
Peru
UK
Can Gre
Tai
Ita
Mal
Kor USA Spa Fra
Arg
Sal
Gua
Tha
Bra
Nic
0
-2
Ind
-4
CR
Phi
Jam
-6
All Countries
Only LA
1.00
0.90
0.80
0.70
0.60
0.50
0.40
0.30
0.20
0.10
0.00
-8
Inflation Persistence
Source: WEO, IMF. Calculations by Banco de México.
15
2. Implications for Monetary Policy
4
Uru
Bol
Ven
2
Par
Ecu
Nic
0
Col
Peru
Mex
Arg
-2
Sal
Chi
Pan
Ire UK
Ita Can
Kor
Spa
Fra Tai
USA
HK
Por
Gre
Gua
Sin
Ger
Jap
Mal
Thai
Bra
-4
Ind
Bol
Phil
Jam
-6
All Countries
Only LA
30
25
20
15
10
5
-8
0
Change in Inflation from 2005 to 2007
2005 – 2007 Inflation Change and Low Inflation Regime
Duration of Low Inflation Periods (Years)
Source: WEO, IMF. Calculations by Banco de México.
16
2. Implications for Monetary Policy
2005 – 2007 Inflation Change and CPI Food Weights
Uru
Bol
Ven
2
Chi Pan
Ire
HK
Can
Jap Col
Mex
Ita
Por
Ecu
Sin
Ger
UK
0
Kor Fra
USA Gre Spa
-2
Tai
Par
Nic
Peru
Arg Mal
Thai
Gua
Bra
-4
CR
Ind
Phil
All Countries
-6
Jam
Only LA
60
50
40
30
20
10
-8
0
Change in Inflation from 2005 to 2007
4
CPI Food Weight
Source: WEO, IMF. Calculations by Banco de México.
17
2. Implications for Monetary Policy
Cumulative Change in Policy Target Rates and Inflation Persistence
200
Uru HK Col
Gre
Chi
Ire Spa
Ger Por
Mal Mex Kor
Ita
Jap UK Fra
Gua
Peru
100
0
-100
Can
Bra
Ind
Thai
-200
USA
-300
-400
-500
All Countries
-600
Only LA
CR
1.0
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
-700
0.0
Cumulative Change in Policy Rate (Basis
Points)
300
Inflation Persistence
Source: WEO, IMF. Calculations by Banco de México.
18
2. Implications for Monetary Policy
Cumulative Change in Policy Target Rates and Low Inflation Regime
Uru
200
HK
Col
Gua
100
Per
Mex
0
Chi
Gre
Ita Ire Fra Kor Ger
Jap
Spa
Mal
UK
Por
-100
Ind
-200
Can
Tha
USA
Bra
-300
-400
-500
All Countries
-600
30
20
15
10
0
-700
25
Only LA
CR
5
Cumulative Change in Policy Rate
(Basis Points)
300
Duration of Low Inflation Periods (Years)
Source: WEO, IMF. Calculations by Banco de México.
19
2. Implications for Monetary Policy
Cumulative Change in Policy Rate (Basis
Points)
Cumulative Change in Policy Target Rates and CPI Food Weights
600
400
Uru
HK
Col
Ger Kor Ita Gre SpaMex Chi
Por
Ire
Jap
Mal
UK
Can
Ind
Tha Bra
US
Fra
200
0
-200
Gua
Per
-400
All Countries
-600
Only LA
CR
60
50
40
30
20
10
0
-800
CPI Food Weight
Source: WEO, IMF. Calculations by Banco de México.
20
2. Implications for Monetary Policy

The optimal monetary policy response to “creeping
inflation” depends on each country’s particular
circumstances:
 The inflationary history of the country and, in particular, the
extent to which a low inflation equilibrium has been
sustained.
 The weight that food and energy goods have on the CPI.
 The degree of persistence that each economy’s inflation
process exhibits to price shocks.
 The phase of the cycle the country is located in.
 The impact of the current environment on the country’s
terms of trade.
21
2. Implications for Monetary Policy

The evidence suggests that the impact on inflation
levels and inflation volatility of the worldwide shocks we
have observed in the past years tends to be
heterogeneous across countries. In particular:
 Inflation seems to have responded more to the price
shocks in countries that still exhibit a higher degree of
inflation persistence.
 Inflation volatility seems to be larger in those countries
where the weight of foodstuffs in their consumer prices
is higher, as well as in countries where the attainment
of a low inflation equilibrium has been more recent.
22
2. Implications for Monetary Policy

Thus, the same external shocks may imply different
monetary responses in different countries, given their
own specific characteristics.
 In particular, countries that face higher risks of
suffering large inflation increases and price volatility
(due to their consumption baskets and their inflation
history) may have found themselves in the need to
respond more aggressively to the current price shocks
than other countries.

Indeed, the evidence does suggest that countries that
are more vulnerable in these terms have acted
accordingly, by restricting their monetary policy stance.
23
2. Implications for Monetary Policy

Given the evidence in the first part of this talk, a relevant
question we should try to address with more research is:
for how long will we be facing the current high commodity
inflation regime?

Up to this point, the discussion has centered on the policy
responses to the current environment, given the policy
frameworks that the central banks currently have.

The answer to the question posed above could
nonetheless have implications for the issue of whether
central banks should rethink the definition of their
monetary policy objectives.
24
Outline
1. Real Food and Oil Price Changes
2. Implications for Monetary Policy
3. Additional Considerations
3. Additional Considerations

Creeping inflation from the current shocks to energy and food
prices may imply a restrictive bias in the monetary policy
stance:

This is especially true in countries where inflation is persistent,
the low inflation equilibrium has not been sustained for a long
time and where food and energy have a large weight in
consumers’ spending.

This, in turn, reflects the high costs that a breakdown of
expectations-based nominal anchors that sustain the lowinflation equilibrium may have on these economies’
performance.

Indeed, some countries may face a combination of the above
mentioned features that may lead them to maintain a restrictive
bias in their monetary policy, even when they may be currently
facing the low phase of their business cycle.
26
3. Additional Considerations

The issues raised above focus on the implications of this high
inflation regime for monetary policy.

We have to ask to what extent we need to consider a more
broad view of the policy response that we should undertake,
given this environment. In particular we need to ask:
 Which other policy instruments are available to face the
current environment?
 What is the optimal mix of policy responses to this
environment, in order to minimize negative effects on
welfare?
27
3. Additional Considerations

The policy mix clearly depends on the structure of each
economy and on the shocks that each country has faced:
 Those who faced an improvement in terms of trade
may use specific policies to redistribute the aggregate
gains of the shocks to those groups that may have
been hurt from price changes.
 Those that have faced a terms of trade deterioration
also need to determine the optimal policy mix to
minimize the welfare costs of this shock.
28
3. Additional Considerations

Fiscal policy
 May be helpful to redistribute losses (or gains, if terms of
trade have improved), across different economic agents.

Competition policy
 A non-competitive environment may exacerbate the impact
of price shocks on domestic markets. Thus, antitrust
agencies should avoid collusive practices in this
environment of high price increases.
29
Appendix
Real Crude Oil Price Changes
(Proportion of Time Above Threshold)
0.8
Jan. 81 - Jan. 87
Feb. 87 - Jul. 91
Aug. 91 - Mar. 99
0.6
Apr. 99 -Mar. 08
0.5
0.4
0.3
0.2
0.1
Source: IMF. Calculations by Banco de México.
144
136
128
120
112
96
104
Threshold
88
80
72
64
56
48
40
32
24
16
8
0.0
0
Proportion above Threshold .
0.7
30
Appendix
Real Crude Oil Price Changes
(Mean Above Threshold)
60
Jan. 81 - Jan. 87
50
Feb. 87 - Jul. 91
Apr. 99 -Mar. 08
40
30
20
10
144
136
128
120
112
104
96
88
80
72
64
56
48
40
32
24
16
8
0
0
Conditional Mean
Aug. 91 - Mar. 99
Threshold
Source: IMF. Calculations by Banco de México.
31