Targeting Central Banks Research Articles

Monetary Policy and Relative Price Shocks in South Africa and Other Inflation Targeters

When faced with a relative price shock, monetary authorities often aim to contain its second round effects on inflation while accepting first round effects. We analyze the experience of South Africa and other inflation targeters to explore whether and when this policy prescription implies changing the monetary policy stance. Inflation targeting central banks differ on how aggressively they typically react to relative price shocks, reflecting differences in resilience of underlying inflation to such shocks. An examination of individual policy decisions reveals the importance of the broader economic context in framing the responses to relative price shocks.

Securing Sustainable Price Stability: Should Credit Come Back From the Wilderness?

We argue that in order to achieve price stability in a sustainable way, central banks should consider paying greater attention to credit in their monetary policy strategies than is generally the case at present. Specifically, simply setting monetary policy so that a two-year inflation forecast is at the central bank's target may, on occasions, be less than optimal. In particular, the central bank may wish to deviate from such a strategy when developments in the financial system are exposing the macroeconomy to materially increased risk. Doing so calls for longer policy horizons together with an explicit incorporation into policy decisions of the balance of risks in the outlook. One important indicator that risk is building up is unusually sustained and rapid credit growth occurring alongside unusually sustained and large increases in asset prices (financial imbalances). Building on previous work, we show that empirical proxies for financial imbalances contain useful information about subsequent banking crises, output and inflation beyond traditional two-year policy horizons. On the basis of Taylor rule-type descriptions of policy, we also investigate the response of central banks to financial imbalances. We find evidence that, at least until recently, central banks generally either have not responded to imbalances systematically or, to the extent that they have, have done so asymmetrically, loosening policy further than normal in the face of their unwinding but not tightening it beyond normal as they build up.

Endogenous Money: Structuralist and Horizontalist

While the mainstream long argued that the central bank could use quantitative constraints as a means to controlling the private creation of money, most economists now recognize that the central bank can only set the overnight interest rate - which has only an indirect impact on the quantity of reserves and the quantity of privately created money. Indeed, in order to hit the overnight rate target, the central bank must accommodate the demand for reserves, draining the excess or supplying reserves when the system is short. Thus, the supply of reserves is best characterized as horizontal, at the central bank's target rate. Because reserves pay relatively low rates, or even zero rates (as in the United States), banks try to minimize their holdings. Over time, they continually innovate, as they seek to minimize costs and increase profits. This includes innovations that reduce the quantity of reserves they need to hold (either to satisfy legal requirements, or to meet the needs of check cashing and clearing), and also innovations that allow them to increase the rate of return on equity within regulatory constraints, such as those associated with Basle agreements. Such behavior has been a central concern of the structuralist approach — which argued that it is too simplistic to hypothesize simple horizontal loan-and-deposit supply curves.

Assessing inflation targeting through intervention analysis

The aim of this paper is to deal with the empirical aspects of the ‘new’ monetary policy framework, known as Inflation Targeting. Applying Intervention Analysis to multivariate Structural Time Series models, which avoids certain biases encountered in the use of conventional regression estimators, new empirical evidence is produced in the case of a number of OECD countries. These results demonstrate that although Inflation Targeting has gone hand-in-hand with low inflation, the strategy was introduced well after inflation had begun its downward trend. But, then, Inflation Targeting ‘locks in’ low inflation rates. The evidence produced in this paper suggests that non-Inflation Targeting central banks have also been successful on this score.

Perhaps the FOMC Did What it Said it Did: An Alternative Interpretation of the Great Inflation

This paper uses real-time briefing forecasts prepared for the Federal Open Market Committee (FOMC) to provide estimates of historical changes in the design of US monetary policy and in the implied central bank target for inflation. Empirical results and FOMC transcripts support a neglected interpretation of policy during the Great Inflation of the 1970s.

Para Politikasında Şeffaflık ve Enflasyonist Beklentilerin Yönlendirilmesi

In recent years, central banks paid a great attention to the transparency of monetary policy. The clarity in central bank's target and the transparency how it achieves this target enable economic units to make correct decisions by eliminating the uncertainty. Thus, inflationary expectations, which are one of the important factors impacting the inflation level, can be reduced and brought to a level in line with the central bank's target. This study demonstrates that inflationary expectations can be managed by the provision of transparency in the monetary policy and this type of monetary policy bears effective outcomes in fighting with inflation.

Endogenous Yield Curve Risk from Central Bank Policy Uncertainty

Due to economic feedback the actual risk in bonds from changes in Federal Reserve policy should generally be smaller than measured using conventional duration measures. We introduce the notion of Federal Reserve policy durations. For example, target inflation duration, which measures the change in the price of a treasury bond that arises from a change in Central Bank target inflation rate that occurs at some time in the future before the maturity of the bond. For Central Banks following a policy setting rule such as a Taylor rule, we derive a simple analytic expression for the target inflation duration of zero coupon Treasury bonds in terms of model economic parameters and the parameters in the Taylor rule. The correction to the traditional duration of a zero coupon bond is proportional, at leading order, to the product of three terms: the Taylor rule output gap coefficient, the coefficient in the economy that determines the response of the output gap to the real rate, and the square of the maturity of the zero coupon bond.

The advantage of showing your hand selectively in foreign exchange interventions

This paper studies the effectiveness of foreign exchange rate targeting by a central bank in a market microstructure framework. Unlike the existing literature, where the intervening central bank either makes its target exchange rate public or hides it completely, we present a model that emphasizes the value of selectively disclosing intervention relevant information to some but not all market participants. We show that if the market's uncertainty over the central bank's target is sufficiently high and if the central bank is targeting the exchange rate away from its fundamental value (attempting to move the exchange rate in the opposite direction of where the fundamental based trade takes it) selectively disclosing the exchange rate target improves the effectiveness of the intervention.

Central Bank forecasts and disclosure policy: Why it pays to be optimistic

In a model with forward-looking behavior, we study disclosure policy when a central bank has private information on the future state of the economy. We find that the effects of advance disclosure depend on the presence of uncertainty about policy targets when the shock occurs. With uncertainty about policy targets, disclosure is harmless to current outcomes, owing to the strong dependence of inflation expectations on policy actions, which induces the central bank to focus exclusively on price stability. If the central bank's targets are common knowledge, disclosure of future shocks impairs stabilization of current inflation and output.

The central bank and speculators in the foreign exchange market under asymmetric information: A strategic approach and evidence

This paper studies the central bank sterilized intervention in the foreign exchange market in an asymmetric information framework. The central bank has inside information of its target, and the speculators have private information of fundamentals. The model suggests that if market expectations are precise about the central bank's target, or about liquidity trades, the foreign exchange market will more likely move in the direction opposite to the central bank's intervention direction. Following the hypothesis of Diebold and Nerlove [Diebold, F. X., & Nerlove, M. (1989). The dynamics of exchange rate volatility: A multivariate latent factor Arch model. Journal of Applied Econometrics, 4, 1–21] regarding the relationship between preciseness of information and the market volatility, the model provides a possible theoretical explanation for Hung's [Hung, J. H. (1997). Intervention strategies and exchange rate volatility: A noise trading perspective. Journal of International Money and Finance, 16, 779–793] noise trading channel hypothesis. Empirically, the paper shows that actual daily intervention data of the Fed, the Bundesbank, and the BOJ generally support the theoretical implications.

HUNGARY'S EUROZONE ENTRY DATE: WHAT DO THE MARKETS THINK AND WHAT IF THEY CHANGE THEIR MINDS?

This article investigates the potential impact of a shift in market expectations about a country's eurozone entry date on long‐term yields and the spot exchange rate in a simple uncovered interest parity (UIP) framework. The results suggest that the size of the reactions depend on how far the entry date is postponed, how far current inflation is from the Maastricht‐satisfying level, and whether the credibility of the central bank's target inflation path is sensitive to changes in the expected entry date. In the empirical part, the authors apply the framework for Hungary and draw some policy conclusions for the timing of ERM II entry. (JEL E44, E52, F33)

Should Central Banks Target Consumer Prices or the Exchange Rate?

In this article we consider two arguments suggesting that monetary authorities in an open economy should target output price inflation and not consumer price inflation. The first suggests that output price inflation corresponds to the distortions caused by price rigidity. The second shows how policy rules involving consumer price inflation can induce instability because of the feedback from interest rates to consumer price inflation via the exchange rate. We examine both arguments in the context of an open economy which is subject to a range of shocks. We show that both arguments remain robust but that there is a case for including a terms of trade or real exchange rate gap term in the authorities' welfare function alongside the output gap and output price inflation.

The Svensson versus McCallum and Nelson Controversy Revisited in the BMW Framework

This note shows that the Svensson versus McCallum and Nelson controversy battled in the Federal Reserve Bank of St. Loius Review (September/ October 2005) can be mapped into a static version of a New Keynesian macro model that consists of an IS-equation, a Phillips curve and an inflation targeting central bank (e.g., Bofinger, Mayer, Wollmershauser, (2006);Walsh (2002)). As a contribution to literature we supplement the controversy by a forceful graphical analysis. The general debate centers on the question by which notion monetary policy should be implemented. The two sides have fundamentally opposite views on this issue. Svensson argues for targeting rules as a notion of optimal monetary policy, whereas McCallum and Nelson promote simple instrument rules. In this note we systematically analyze these two categories of monetary policy rules. In particular we show that the rule discussed by McCallum and Nelson (2005) imposes different degrees of variability on the economy compared to a targeting rule when monetary policy falls prey to measurement error. To our opinion the hybrid Taylor rule developed by McCallum and Nelson contradicts the original idea of simple rules as a heuristic for monetary policy making and should be rebutted for practical reasons.

Optimal monetary policy and the role of hybrid inflation-price-level targets

This study investigates the role of hybrid inflation-price-level targets as a solution to the well-known stabilization bias problem that arises under discretionary policies. The analysis shows that social welfare will be improved by employing a weighted average of inflation and price level as one of the central bank's target variables in addition to the output gap growth target. The reason is that imposing the optimal hybrid target will reduce inflation variability in a highly efficient way. In particular, the optimal hybrid regime outperforms other previously suggested regimes when the degree of inflation persistence is moderate.

Learning about Monetary Policy Rules in Small Open Economies

We evaluate the expectational stability (E-stability) of rational expectations equilibrium in a simple New Keynesian small open economy model. In particular, we extend Bullard and Mitra (JME, 2002) results of E-stability in closed economy to an open economy framework by evaluating Taylor-type rules. The main results are the following: a) the stability conditions under learning in open economies are isomorphic to the closed economy counterpart when the central bank targets contemporaneously either domestic price inflation or CPI inflation; b) the problem of instability under learning becomes more serious in open economies when the central bank reacts actively to expected consumer price inflation (CPI). Thus, unlike Bullard and Mitra (2002) the Taylor's principle does not necessarily induce both determinate and learnable rational expectation equilibria, where the degree of openness plays a crucial role c) it is easier for the economy to get into an unstable region when a central bank reacts to expected movements in the exchange rate along with an actively reaction to expected CPI inflation.

A Theory of Managed Floating

After the experience with the currency crises of the 1990s, a broad consensus has emerged among economists that such shocks can only be avoided if countries that decided to maintain unrestricted capital mobility adopt either independently exchange rates or very hard pegs (currency boards, dollarisation). As a consequence of this view which has been enshrined in the so-called impossible trinity all intermediate currency regimes are regarded as inherently unstable. As far as the economic theory is concerned, this view has the attractive feature that it not only fits with the logic of traditional open economy macro models, but also that for both corner solutions (independently exchange rates with a domestically oriented interest rate policy; hard pegs with a completely exchange rate oriented monetary policy) solid theoretical frameworks have been developed. Above all the IMF statistics seem to confirm that intermediate regimes are indeed less and less fashionable by both industrial countries and emerging market economies. However, in the last few years an anomaly has been detected which seriously challenges this paradigm on exchange rate regimes. In their influential cross-country study, Calvo and Reinhart (2000) have shown that many of those countries which had declared themselves as independent floaters in the IMF statistics were charaterised by a pronounced of floating and were actually heavily reacting to exchange rate movements, either in the form of an interest rate response, or by intervening in foreign exchange markets. The present analysis can be understood as an approach to develop a theoretical framework for this behaviour that - even though it is widely used in practice - has not attracted very much attention in monetary economics. In particular we would like to fill the gap that has recently been criticised by one of the few middle-ground economists, John Williamson, who argued that managed is not a regime with well-defined rules (Williamson, 2000, p. 47). Our approach is based on a standard open economy macro model typically employed for the analysis of monetary policy strategies. The consequences of independently and market determined exchange rates are evaluated in terms of a social welfare function, or, to be more precise, in terms of an intertemporal loss function containing a central bank's final targets output and inflation. We explicitly model the source of the observable fear of by questioning the basic assumption underlying most open economy macro models that the foreign exchange market is an efficient asset market with rational agents. We will show that both policy reactions to the fear of (an interest rate response to exchange rate movements which we call indirect floating, and sterilised interventions in the foreign exchange markets which we call direct floating) can be rationalised if we allow for deviations from the assumption of perfectly functioning foreign exchange markets and if we assume a central bank that takes these deviations into account and behaves so as to reach its final targets. In such a scenario with a high degree of uncertainty about the true model determining the exchange rate, the rationale for indirect is the monetary policy maker's quest for a robust interest rate policy rule that performs comparatively well across a range of alternative exchange rate models. We will show, however, that the strategy of indirect still bears the risk that the central bank's final targets might be negatively affected by the unpredictability of the true exchange rate behaviour. This is where the second policy measure comes into play. The use of sterilised foreign exchange market interventions to counter movements of market determined exchange rates can be rationalised by a central bank's effort to lower the risk of missing its final targets if it only has a single instrument at its disposal. We provide a theoretical model-based foundation of a strategy of direct in which the central bank targets, in addition to a short-term interest rate, the nominal exchange rate. In particular, we develop a rule for the instrument of intervening in the foreign exchange market that is based on the failure of foreign exchange market to guarantee a reliable relationship between the exchange rate and other fundamental variables.

INFLATION PERSISTENCE AND FLEXIBLE PRICES*

If the central bank follows an interest rate rule, then inflation is likely to be persistent, even when prices are fully flexible. Any shock, whether persistent or not, may lead to inflation persistence. In equilibrium, the dynamics of inflation are determined by the evolution of the spread between the real interest rate and the central bank's target. Inflation persistence can be characterized by a vector autocorrelation function relating inflation and output. This article shows that a flexible‐price, general‐equilibrium business cycle model with money and a central bank using an interest rate target can account for such inflation persistence.

Bias in Federal Reserve Inflation Forecasts: Is the Federal Reserve Irrational or Just Cautious?

This paper documents that inflation forecasts of the Federal Reserve systematically under-predicted inflation before Volker's appointment as Chairman and systematically over-predicted it afterward. It also documents that, under quadratic loss, commercial forecasts have information not contained in the forecasts of the Federal Reserve. It demonstrates that this evidence leads to a rejection of the joint hypothesis that the Federal Reserve has rational expectations and quadratic loss. To investigate the causes of this failure, this paper uses moment conditions derived from a model of an inflation targeting central bank to back out the loss function implied by the forecasts of the Federal Reserve. It finds that the cost of having inflation above the target was larger than the cost of having inflation below it for the post-Volker Federal Reserve, and that the opposite was true for the pre-Volker era. Once these asymmetries are taken into account, the Federal Reserve is found to be rational and to efficiently incorporate the information contained in forecasts from the Survey of Professional Forecasters.

Governance Structures and Decision-Making Roles in Inflation Targeting Central Banks

This paper surveys decision-making roles of governing bodies of central banks that have formally adopted inflation targeting as a monetary framework. Governance practices seek to balance institutional independence needed for monetary policy credibility with accountability required to protect democratic values. Central bank laws usually have price stability as the primary monetary policy objective but seldom require an explicit numerical inflation target. Governments are frequently involved in setting targets, but to ensure operational autonomy, legal provisions explicitly limit government influence in internal policy decision-making processes. Internal governance practices differ considerably with regard to the roles and inter-relationships between the policy, supervisory, and management boards of a central bank.

Fiscal Policy: Institutions versus Rules

Fiscal discipline is as much needed as monetary discipline. Many countries have attempted to counter the deficit bias by adopting fiscal rules that typically set a limit to their annual budget deficits. The record is not satisfactory; rules are either too lax or too tight and then ignored. This article suggests that the solution is to adopt the approach followed by inflation targeting central banks, with great success. Independent and accountable Fiscal Policy Committees, given the task of achieving debt targets and the authority to decide - or recommend - annual deficits, will be free from the deficit bias. This will allow them to exercise discretion in the short run while delivering debt sustainability in the long run.