Abstract
Inflation scenarios in forecasts of the Central Bank of Iceland (CBI) appear to converge to the inflation target (2.5%) in 8-9 quarters. We ask whether this is a coincidence or an inherent property of the CBI’s model, QMM. We formulate a sub-model, containing equations for inflation, inflation expectations, wages, exchange rate and the policy interest rate. We find that rapid convergence toward the inflation target is a property of the QMM when a Taylor-rule is included in the model. Underlying is an inflation expectations equation which assumes a high degree of credibility of the CBI. This equation, however, lacks empirical underpinnings. When we replace the QMM expectations equation with an estimated equation, a more realistic picture emerges where the Central Bank has to raise the policy rate considerably higher than in QMM scenarios and it takes much longer to reach the inflation target.
Highlights
Inflation scenarios in forecasts of the Central Bank of Iceland (CBI) appear to converge to the inflation target (2.5%) in 8-9 quarters
Among other things, that the inflation target is a kind of mirage; viz. that the CBI routinely announces that inflation certainly exceeds the target and the policy interest rate must be increased, but that inflation will subside over the few quarters, making it possible to lower the policy interest rate again
This indicates that the CBI faces a credibility problem: in the bank’s view, inflation expectations are the principal determinant of inflation; in order to attain its objective the bank must persuade the market that inflation will be tamed, but that has proven a difficult task
Summary
Since March 2001 monetary policy in Iceland has centred on the Central Bank of Iceland (CBI) applying its policy interest rate in support of the objective of limiting inflation to about 2.5% ‚within an acceptable [time] horizon‛.3 This approach – monetary policy with an inflation target – has recently attracted controversy; the CBI’s policy interest rate has been raised from 5.16% in February 2003 to 15.5% in April 2008, the attempt to control inflation has not been successful, with inflation at the time we write this in June 2008 running at an annual rate of about 12%. Since March 2001 monetary policy in Iceland has centred on the Central Bank of Iceland (CBI) applying its policy interest rate in support of the objective of limiting inflation to about 2.5% ‚within an acceptable [time] horizon‛.3. To understand how the CBI’s projections unfold over time the model’s dynamic characteristics must be examined These concern the evolution of inflation and inflation expectations and other related variables when looking several quarters into the future. An attempt is made to approach its core by defining a partial model based on several important equations of the model – the ‚heart‛ of the model – which are the principal determinants of the policy interest rate’s effectiveness over a relatively short period of time These are equations which project inflation, inflation expectations, the policy interest rate, wages, and the exchange rate.
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