Explicit Inflation Targeting Research Articles

Reconstructing Colombia's recent history of monetary policy from 1990 to 2010

Este articulo presenta una reconstruccion de la historia de la politica monetaria del Banco Central de Colombia (Banco de la Republica) en el periodo 1990 a 2010 durante el cual se implemento una politica explicita de metas de inflacion en octubre de 2000. Para lograr nuestro objetivo, desarrollamos una regla teorica de Taylor modificada con suavizacion de tasa de interes para una economia pequena y abierta; consecuentemente, estimamos un modelo de cambios de regimen (Markov switching) de dos regimenes, el cual admite que las fechas de cambio de regimen sean determinadas de manera endogena. Encontramos que uno de los regimenes, que corresponde al periodo 2000 a 2010, coincide con fijacion explicita de las metas de inflacion por parte del Banco de la Republica, en donde la tasa de inflacion tuvo un comportamiento de serie estacionaria, consistente con que el Banco de la Republica cumplio con el principio de Taylor. Dicho regimen de politica monetaria se habia presentado en algunos trimestres antes del 2000, pero no como el regimen predominante. El otro regimen prevalecio durante la decada de los noventa, pero no cumplio con el principio de Taylor en general debido a que permitio un comportamiento de raiz unitaria de la tasa de inflacion. Finalmente, no encontramos evidencia de que el Banco de la Republica haya cambiado su comportamiento en cuanto a las fluctuaciones del producto durante el periodo estudiado.

Explicit inflation targets and central bank independence: friends or foes?

The paper studies the relationship between two institutional innovations in monetary policy of the past few decades: central bank independence (CBI) and explicit inflation targeting (EIT). The aim is to make inferences about the optimal institutional design of monetary policy, and the right sequencing of policy reform. Our reduced-form model unifies several approaches in the literature, and offers three novel institutional findings (that we square with existing empirical evidence). First, instrument-CBI is a complement to EIT, whereas goal-CBI acts as a strategic substitute for EIT in ensuring low inflation and policy credibility. Second, out of these two ‘commitment technologies,’ EIT is shown to be socially superior to goal-CBI. Third and controversially, countries that first implement goal-CBI are then less likely to adopt the desirable EIT regime. This is because independent central bankers may have less need to do so (their independence partly substitutes for EIT), as well as less willingness to do so (due to a higher degree of accountability associated with a transparently legislated target). Our analysis therefore implies that developing and emerging market countries should go down the New Zealand route—legislate EIT together with instrument-CBI, but stay clear of goal-CBI. Unfortunately, many transition countries have followed the opposite Fed/Bundesbank route, which we show may have adverse welfare consequences through several channels.

The changing relation between the Canadian and U.S. yield curves

The term structures of Canada and of the United States, two countries with historically interdependent economic ties, have been closely linked. We investigate the link between Canadian and U.S. yield curves and show previously strong correlations between yield curve components dissipate after Canadian monetary policy reforms in the early 1990s. We attribute the separated ties to the adoption of explicit inflation targets in 1991 and the maintenance of credibility in price stability as a central policy goal by the Bank of Canada. The effect is particularly evident in the diminished cross-country correlations of the short term bond yields. Additionally, there exists strong evidence of cointegration before the reforms, evidence which weakens after the policy change date. Lastly, the results on the term structure are shown using a vector autoregression with an endogenously determined break date for Canadian and U.S. estimates of the three-factor Nelson and Siegel (1987) yield curve model.

Asymmetric Taylor reaction functions of the ECB: An approach depending on the state of the economy

We introduce a new approach to estimate asymmetric Taylor reaction functions where asymmetries depend crucially on the state of the economy which is in the Taylor rule framework the combination of inflation and output deviations. Thus we categorize the sample into four subsamples which correspond to all possible combinations concerning inflation and output deviations. Moreover we introduce a quadratic term of inflation and the output gap in the estimation equation for each state in order to capture possible non-linearities within each state. The approach is tested using data for the ECB because the ECB has communicated an explicit inflation target.

Switching Monetary Policy Regimes and the Nominal Term Structure

In this paper I propose a regime switching approach to explain why the US nominal yield curve has been on average steeper since the mid-1980's than during the Great Inflation of the 1970's. I show that, once the possibility of regime switches in the short-rate process is incorporated into investors' beliefs, the average yield curve slope will generally contain a new component called 'level risk'. Level risk estimates based on a Markov-Switching VAR model of the US economy are provided. I find that the level risk was large and negative during the Great Inflation, reflecting a possible switch to lower short-rate levels in the future. The level risk since the mid-1980's has been moderate and positive, reflecting a small but still relevant possibility of return to the regime of the 1970's. These results are replicated in a dynamic general equilibrium model where the monetary policy rule followed by the Fed switches between an active and a passive regime. The model also explains why in recent decades the US yield curve has been on average steeper than in countries that adopted explicit Inflation Targeting frameworks.

“Ex-ante” Taylor rules and expectation forming in emerging markets

The success of monetary policy in stabilizing inflation depends substantially on its influence on expectation formation of private agents. This paper provides a novel perspective on the expectation forming process of financial markets. Using forecasts for the short-term interest rate, the inflation rate, and output growth for 10 emerging markets in Latin-America, central and eastern Europe, we estimate expected (“ex-ante”) Taylor-type rules. We find evidence for significant differences in the expectation formation process in the sense that the well-known Taylor principle fairly holds for only some countries, while for the other countries it does not. The adaption of an explicit inflation targeting regime seems to explain this cross-country differences.

Inflation Nutters? Modelling the Flexibility of Inflation Targeting

Opponents of explicit inflation targeting (including ex-Chairman Greenspan) have argued that a commitment to a numerical inflation target is likely to reduce monetary policy flexibility, and hence increase output volatility. Our paper demonstrates that this claim may fail to account for the anchoring effect of explicit targets on expectations and wages—found in the data by a number of empirical studies. We do so in a novel, dynamic game theoretic framework with asynchronous moves that endogenizes the frequency of the private sector’s actions. We derive the conditions under which an explicit long-term inflation target makes the behaviour of private agents rationally inattentive and anchored. This is through enhancing monetary policy credibility, which leads private agents to reconsider expectations and wages less frequently to minimize the cost of processing information and/or wage negotiations. Such anchoring makes the policymaker’s interest rate instrument more effective in stabilization, giving it greater leverage over the real rate. This implies that an explicit inflation target may improve the variability tradeoff, i.e. shift the policy frontier inwards. It can therefore make both inflation and output less variable in equilibrium, unlike what inflation targeting sceptics argue. We show that our results are consistent with existing empirical evidence, and discuss them in light of the global financial crisis. The policy implication is that the Federal Reserve, the Swiss National Bank, the Bank of Japan, and the European Central Bank should be more explicitly committed to a long-run inflation target.

DOES INFLATION TARGETING ANCHOR LONG-RUN INFLATION EXPECTATIONS? EVIDENCE FROM THE U.S., UK, AND SWEDEN4

We investigate the extent to which inflation expectations have been more firmly anchored in the United Kingdom–-a country with an explicit inflation target–-than in the United States–-a country with no such target–-using the difference between far-ahead forward rates on nominal and inflation-indexed bonds as a measure of compensation for expected inflation and inflation risk at long horizons. We show that far-ahead forward inflation compensation in the U.S. exhibits substantial volatility, especially at low frequencies, and displays a highly significant degree of sensitivity to economic news. Similar patterns are evident in the UK prior to 1997, when the Bank of England was not independent, but have been strikingly absent since the Bank of England gained independence in 1997. Our findings are further supported by comparisons of dispersion in longer-run inflation expectations of professional forecasters and by evidence from Sweden, another inflation-targeting country with a relatively long history of inflation-indexed bonds. Our results support the view that an explicit and credible inflation target helps to anchor the private sector's views regarding the distribution of long-run inflation outcomes. (JEL: E31, E52, E58)

Using wavelets to measure core inflation: The case of New Zealand

This paper uses wavelets to develop a core inflation measure for inflation targeting central banks. The analysis is applied to the case of New Zealand – the country with the longest history of explicit inflation targeting. We compare the performance of our proposed measure against some popular alternatives. Our measure does well at identifying a reliable medium-term trend in inflation. It also has comparable forecasting performance to standard benchmarks.

Decisão de preços em economias monetárias e metas de inflação: a difícil conciliação entre crescimento e estabilidade de preços

Atualmente um número considerável de países adota explicitamente o regime de metas para a inflação como uma referência para a condução da política monetária e como forma de afetar as expectativas do público. A política monetária, sob o regime de metas de inflação, é conduzida fundamentalmente baseada na manipulação de um único instrumento de controle da inflação - a taxa de juros. Contudo, advoga-se que a insistência no uso exclusivo desse instrumento traz consequências negativas para a formação de expectativas sobre o potencial de crescimento da economia. Nesse sentido, o presente trabalho tem como objetivo explicitar o processo de formação de preços em economias de mercado e discutir como a política monetária, sob o regime de metas de inflação, atua de maneira satisfatória sobre a formação de expectativas para a inflação, mas de maneira nociva sobre a formação das expectativas de crescimento do produto a longo prazo.

A NOTE ON THE ANCHORING EFFECT OF EXPLICIT INFLATION TARGETS

Empirical literature provided convincing evidence that explicit (i.e., legislated) inflation targets anchor expectations. I propose a novel game theoretic framework with generalized timing that allows us to formally capture this beneficialanchoring effect. Using the framework I identify several factors that influence whether and how strongly expectations are anchored, namely (i) the public's cost of decision making, (ii) the public's inflation aversion, (iii) the slope of the Phillips curve, (iv) the magnitude of supply shocks, (v) the degree of central bank conservatism, and under many (but not all) circumstances, (vi) the explicitness of the inflation target.

Extracting inflation expectations and inflation risk premia from the term structure: A joint model of the UK nominal and real yield curves

This paper analyses the UK interest rate term structure over the period since October 1992, when the United Kingdom adopted an explicit inflation target, using an affine term structure model estimated using both government bond yields and survey data. The model imposes no-arbitrage restrictions across nominal and real yields, which enables interest rates to be decomposed into expected real policy rates, expected inflation, real term premia and inflation risk premia. The model is used to shed light on major developments over the period, including the impact of Bank of England independence and the low real bond yield ‘conundrum’.

A Two-Headed Dragon for Monetary Policy

The current financial crisis has been the key global economic event since it unfolded in earnest in early August 2007. The Federal Reserve has taken aggressive actions—both conventional and unconventional—to counteract the economic and financial fallout. Among these actions have been a number of new special lending programs created under section 13(3) of the Federal Reserve Act, which had not been employed since the 1930s. Academics, policymakers, and the general public have shown great interest in the Federal Reserve's new programs. In this paper, I emphasize two medium-term risks that the Federal Reserve now faces as it continues to confront financial market turmoil and recession. The two medium-term risks are opposites of each other, a “two-headed dragon.” One is a Japanese-style deflation trap, and the other is a breakout of inflation like that seen during the 1970s. An explicit inflation target would help mitigate these very real risks.

Extracting Inflation Expectations and Inflation Risk Premia from the Term Structure: A Joint Model of the UK Nominal and Real Yield Curves

This paper analyses the nominal and real interest rate term structures in the United Kingdom over the fifteen-year period that the UK monetary authorities have pursued an explicit inflation target, using a four-factor essentially affine term structure model. The model imposes no-arbitrage restrictions across nominal and real yields, enabling us to decompose nominal forward rates into expected real short rates, expected inflation, real term premia and inflation risk premia. We find that inflation risk premia and longer-term inflation expectations fell significantly when the Bank of England was made operationally independent in 1997. The 'conundrum' of unusually low long-term real rates that began in 2004 is mainly attributed by the model to a fall in real term premia, though a significant part of the fall is left unexplained. The relative inability of the model to fit long real forwards during much of this recent period may reflect strong pension fund demand for index-linked bonds. Moreover, the model decompositions suggest that these special factors affecting the index-linked market may also partly account for the contemporaneous rise in longer-horizon inflation breakeven rates.

Characterising the Inflation Targeting Regime in South Korea

This paper attempts at characterising South Korean monetary policy in the period of explicit inflation targeting started in 1999. We explain Korean interest rates in relation to an estimated macro-model, assuming that monetary policy is set optimally. This allows us to obtain the central bank's parameters in the policy objective function. During the IT regime, the data support that the Bank of Korea pursued optimal policy geared towards achieving price stability, with the degree of interest rate smoothing being estimated to be considerable. In addition, the central bank loss function is estimated to include negligible weights on output and exchange rate variability.

The Risks of Being Chairman in the Age of Turbulence

The Risks of Being Chairman in the Age of Turbulence

Measuring Monetary Policy Expectations from Financial Market Instruments

This paper reviews the main instruments and associated yield curves that can be used to measure financial market participants' expectations of future UK monetary policy rates. We attempt to evaluate these instruments and curves in terms of their ability to forecast policy rates over the period from October 1992, when the United Kingdom first adopted an explicit inflation target, to March 2007. We also investigate several model-based methods of estimating forward term premia, in order to calculate risk-adjusted forward interest rates. On the basis of both in and out-of-sample test results, we conclude that, given the uncertainties involved, it is unwise to rely on any one technique to measure policy rate expectations and that the best approach is to take an inclusive approach, using a variety of methods and information.

Empirical evidence from fourteen countries with explicit inflation targeting

This article attempts to contribute to the empirical research on inflation targeting (IT) making an inquiry of the relation between macroeconomic variables for 14 countries with explicit IT. The main results denote that the adoption of IT is a good framework for reducing inflation, and thus contributes to diminish interest rate without apparent costs on economic growth, although unemployment increases.

Fiscal-monetary Interactions: The Effect of Fiscal Restraint and Public Monitoring on Central Bank Credibility

This paper offers new insights into the interactions between private agents, the government, and a central bank, and their effect on the outcomes of monetary policy. In a simple game theoretic model we show that, unless there is public monitoring, impatient governments will be tempted to override or outmaneuver the central bank and create surprise inflation to boost output. This both undermines the government's reputation for sound fiscal policies and reduces the central bank's credibility. The result is not only higher and more volatile inflation but also sub- optimal output. More importantly, it is also shown that this is likely to occur even if the central banker is fully independent and the government is always patient. In contrast, if the public monitors sufficiently carefully, the central bank is never overridden and monetary policy can be credible even under an impatient government. We derive the general conditions under which each scenario occurs and then relate them to the developments in central banking over the past two decades, most notably to the trends towards greater independence, explicit inflation targeting, clearer communication and transparency. Interestingly, transparency is shown to reduce the variability of both inflation and output (by reducing the monitoring cost and making publicmonitoringmorelikely)whichisin contrast to theusualtransparency literature with a single policymaker which supposes a transparency-volatility trade-off.

An explicit inflation target as a commitment device

This paper shows an avenue through which a numerical long-run inflation target ensures low inflation and high credibility; one that is independent of the usual Walsh incentive contract. Our novel game theoretic framework – a generalization of alternating move games – formalizes the fact that since the target is explicit (legislated), it cannot be frequently reconsidered. This ‘explicitness’ therefore serves as a commitment device. There are two key results. First, it is shown that if the inflation target is sufficiently rigid/explicit relative to the public’s wages, low inflation is time consistent and hence credible even if the policymaker’s output target is above potential. Second, it is found that the central banker’s optimal explicitness level is decreasing in the degree of his patience/independence (due to their substitutability in achieving credibility). Our analysis therefore offers an explanation for the ‘inflation and credibility convergence’ over the past two decades as well as the fact that inflation targets were legislated primarily by countries that had lacked central bank independence like New Zealand, Canada, and the UK rather than the US, Germany, or Switzerland. We show that there exists fair empirical support for all the predictions of our analysis.