Inflation-targeting Central Banks Research Articles

State-dependent oil price shocks on inflation and the efficacy of inflation targeting regime

This paper investigates the state-dependent effect of oil price shocks on domestic inflation using a panel of 30 countries over the period of 2001Q3 to 2022Q4. We find a significant asymmetric effect over different economic states, with a positive and significant effect during economic boom periods, while no significant effect during bust periods. Such state-dependent effect is also quantitatively verified through a dynamic panel threshold framework. As a related question, the paper also examines the effectiveness of inflation targeting (IT) regime in adjusting the oil price shocks-induced inflation. We evaluate the effectiveness of IT regime from several dimensions: whether it contributes to reducing 1) the level of inflation induced by oil price shocks during boom periods, 2) the probability of oil price shocks-induced inflation deviating from inflation target range, and 3) the duration of inflation deviations from the target range. Our findings indicate that central banks under inflation target regime do not mitigate the level and volatility of inflation induced by oil price shocks more effective than the Non-IT regime. Nevertheless, it reduces the duration of oil price shocks-induced inflation that is above the upper limit of target range. As for the causes, our findings suggest that inflation-targeting central banks do not react aggressively to oil price shocks during economic expansions so as to maintain the positive momentum of economic growth and employment, rather than immediately curbing inflation.

Inflation-targeting central bank responses to exchange rate shocks: evidence from Latin America

ABSTRACT This paper examines the impact of real exchange rate shocks on policy interest rates in the five major inflation-targeting economies in LATAM. Using a SVAR model with identification based on sign and short-run restrictions, we find that monetary policy reacts to real exchange rate shocks across all five countries. Specifically, interest rates rise directly in response to a positive real exchange rate shock (appreciation). A subsequent reversal occurs after a few quarters, with statistical significance observed in three countries. Additionally, shocks to the policy rate are demonstrated to effectively induce a real depreciation of the exchange rate.

Monetary Policy Press Releases of 24 Inflation Targeting Central Banks – A Comparison of their Key Features and Complexity

Abstract This paper describes the process of constructing a dataset of available online press releases related to monetary policy decisions published by central banks that have been pursuing a form of inflation targeting. A total of 3,807 documents were considered, as the review encompasses 24 central banks over the past 30 years. To prepare the dataset for text-mining analysis, a cleaning procedure has been performed, which is also presented in detail. The next step was to look at the readability of the documents in order to detect any patterns in its changes. We find that while there is a significant variation between central banks, there is no clear time trend in the readability of the monetary policy press releases, i.e. some central banks tend to have easier-to-read press releases than others, and this does not change with time. In turn, there is a weak indication that following the Global Financial Crisis outbreak and the European Sovereign Debt Crisis apogee, as well as at the time of withdrawing unconventional measures introduced in response to those two emergencies, press releases of advanced economy inflation targeters got temporarily harder-to-read. Overall, this paper can be viewed as a first attempt towards assessing qualitatively central banks’ transparency, with respect to a flagship communication tool of inflation targeters, namely their monetary policy press releases.

Inflation stabilization and normal utilization

This paper presents a model of inflation and distribution that examines the relationship between the employment of labor and the utilization of capital. It features a structural difference between the wage Phillips curve and the price Phillips curve that gives rise to persistent changes in the real wage whenever the inflation-neutral level of activity fails to utilize the existing capital stock at its normal level. Assuming an inflation-targeting central bank that is obliged to run the system around its inflation-neutral level, these changes will reduce the gap between the inflation-neutral level and normal utilization by moving the system along a stable wage curve. In the end this implies that the inflation-neutral level of employment and full or normal utilization of capital will tendentially coincide, lending some support to the Duménil-Lévy thesis that monetary policy makes normal utilization a long-run center of gravity.

Sectoral implications of policy induced household credit expansions

This paper analyses the sectoral implications of household credit expansions in a two-sector open economy model. In the model, policy-induced expansion in banks’ willingness and ability to lend to households results in new lending, boosting aggregate demand and average wages in the nontradable sector. Under fixed relative wages and mark-up pricing in the tradable sector, wage pressures translate into inflationary pressures. The inflation-targeting central bank increases the policy rate to contain inflationary pressures. This intervention causes a real exchange rate appreciation, followed by a reduction in international competitiveness and a contraction of the tradable sector output. This way, the model illustrates that consumer credit expansions can trigger premature deindustrialisation, shifting the sectoral structure away from the high-productivity tradable sector towards the lower-productivity nontradable sector. Key macroeconomic developments from the Turkish economy between 2002 and 2013 are presented to motivate the model.

Teaching post-intermediate macroeconomics with a dynamic 3-equation model

The 3-equation model by Carlin and Soskice (2014) introduces the current consensus in modern monetary macroeconomics to undergraduates through a static framework in which adjustment occurs via the monetary policy rule of an inflation-targeting central bank. In this article, the authors present a dynamic extension of this model and an Excel-based simulation tool for upper-level undergraduate and master’s-level macroeconomics courses. This dynamic framework allows instructors and students to tackle conceptual issues (e.g., understanding a world with output growth and steady inflation) and contemporary applications (e.g., hysteresis and secular stagnation) that are difficult to interpret in static models. Depending on the goals of the course, instructors can either cover the full presentation of the model or instead use the simulation tool to compare scenarios.

Patterns of foreign exchange intervention under inflation targeting

The paper documents the use of foreign exchange intervention (FXI) across countries and monetary regimes, with special attention to its use under inflation targeting (IT). We find significant differences between advanced (AEs) and emerging market economies (EMEs). The former group conduct FXI limitedly and broadly symmetrically, while the use of this policy instrument in EMEs is pervasive and mostly asymmetric, with a bias toward purchasing foreign currency, even after taking precautionary motives into account. Within emerging markets, the use of FXI is common under both IT and non-IT regimes. We find no evidence of FXI being used in response to inflation developments, while strong evidence exists that FXI responds to exchange rate movements, indicating that IT central banks in EMEs have dual inflation/exchange-rate objectives. We also find a higher propensity to overshoot inflation targets in emerging market economies in which FXI is more pervasive.

Covid-19 and monetary–fiscal policy interactions in Canada

We investigate fiscal–monetary policy interactions in Canada over a period that includes the global financial and Covid-19 crises. We relax the assumption that policy regimes are fixed, and estimate interest rate rules for monetary policy and tax rules for fiscal policy that switch stochastically between two regimes. We also use of a structural vector autoregressive (VAR) model to analyze the effects of fiscal policies, similar to the ones undertaken by the Canadian government (and other governments around the world) during the coronavirus pandemic. We find that fiscal policy has been more active than monetary policy and that deficit spending helps to boost economic activity in the short-run. However, the positive effects on real GDP and real private consumption die out with the end of the fiscal stimulus. Long-term interest rates rise, investment falls, and inflation rises, creating problems for an inflation targeting central bank.

Deflation Forces and Inequality

Proximity to short yield zero lower bounds has challenged the inflation targeting central banks of the advanced regions. Central to this development are three-decade declining trends in long yields and underlying real, equilibrium interest rates that have flattened yield curves, restricting “normalisation” and adding deflationary pressure by boosting demand for portfolio money. Inflationary forces, such as fiscal deficits, industrial protection and resurgent regional growth, have proved comparatively weak. In this paper global modelling is used to show that key deflationary forces in these regions include automation, the race to the bottom in capital taxation and immigration. Each is shown to redistribute income so as to expand the welfare gap between the low-skilled and capital owners by 2.5 to 3.5 per cent per year. The high saving rates of capital owners depress real equilibrium rates and their expanding portfolios demand monetary expansion. These forces ensure that the challenges of macro stabilisation and distributional policy making are both intertwined and urgent.

Coordinating expectations through central bank projections

Central banks are increasingly communicating their economic outlook in an effort to manage the public and financial market participants’ expectations. We provide original causal evidence that the information communicated and the assumptions underlying a central bank’s projection can matter for expectation formation and aggregate stability. Using a between-subject design, we systematically vary the central bank’s projected forecasts in an experimental macroeconomy where subjects are incentivized to forecast the output gap and inflation. Without projections, subjects exhibit a wide range of heuristics, with the modal heuristic involving a significant backward-looking component. Ex-Ante Rational dual projections of the output gap and inflation significantly reduce the number of subjects’ using backward-looking heuristics and nudge expectations in the direction of the rational expectations equilibrium. Ex-Ante Rational interest rate projections are cognitively challenging to employ and have limited effects on the distribution of heuristics. Adaptive dual projections generate unintended inflation volatility by inducing boundedly-rational forecasters to employ the projection and model-consistent forecasters to utilize the projection as a proxy for aggregate expectations. All projections reduce output gap disagreement but increase inflation disagreement. Central bank credibility is significantly diminished when the central bank makes larger forecast errors when communicating a relatively more complex projection. Our findings suggest that inflation-targeting central banks should strategically ignore agents’ irrationalities when constructing their projections and communicate easy-to-process information.

A Theory of Growth and Threshold Inflation with Estimates

For an inflation targeting Central Bank, a precise estimate of the threshold inflation in the economy is important. Existing studies provide estimates without any coherent theory of growth and threshold inflation and hence suffer from several limitations about concept and measurement. The present paper attempts to develop such a theory to establish a stable steady state growth solution. It also operationalizes the theory through a model with support from the Indian data for specific components of the model to derive the required functional form. Final estimates in India with annual data from 1995–96 to 2017–18 show that the threshold inflation and associated optimal growth vary considerably as rates of fiscal deficit and current account deficit on the balance of payments vary. The current combinations of the long term four policy targets of 4% inflation; 8% growth; 6% fiscal deficit (to GDP); and 2% current account deficit (to GDP) are internally inconsistent and hence not achievable. Now that there is an opportunity to revise the inflation target for the period after March 2021, the present paper argues for choosing from the menu of internally consistent options for all these four policy targets to avoid unnecessary costs.

Reading the Stars

Following the global financial crisis, significant uncertainty has existed around the U.S. economy’s steady state equilibrium. This paper uses a factor model to provide a new approach to estimating “the stars” (i.e. the neutral interest rate, maximum employment, and the level and growth rate of potential output) that are most consistent with a medium-term equilibrium where inflation converges to the FOMC’s two percent target. It is applicable to any country with an inflation targeting central bank. It also explicitly incorporates estimates of the extensive margin of slack in the labor market, which has proven to be an important factor in describing the post-financial crisis landscape.

Monetary Policy and the Management of Uncertainty: A Narrative Approach

In this paper we explore how macroeconomic theory might be augmented, and the practice of monetary policy better understood, if approached through ideas from social and psychological science. A modern, inflation-targeting central bank faces ‘radical’ uncertainty both in understanding the economy and in knowing how best to communicate policy decisions to influence behaviour. We make use of narrative theory to explore these challenges, drawing on fieldwork with the Bank’s regional Agencies and conversations with staff and policy-makers. We find that the intelligence gathered from conversations with businesses is uniquely useful for both the analysis and communication of monetary policy. Such intelligence embodies knowledge about the plans which are making the future. It also provides insights into how economic agents understand the economy they are creating. These insights can help the Monetary Policy Committee to communicate its policy as a narrative the public understands and commits to. We propose further research to advance and test these ideas.

Patterns of Foreign Exchange Intervention under Inflation Targeting

The paper documents the use of foreign exchange intervention (FXI) across countries and monetary regimes, with special attention to its use under inflation targeting (IT). We find significant differences between advanced and emerging market economies, with the former group conducting FXI limitedly and broadly symmetrically, while the use of this policy instrument in emerging market countries is pervasive and mostly asymmetric (biased towards purchasing foreign currency, even after taking into account precautionary motives). Within emerging markets, the use of FXI is common both under IT and non-IT regimes. We find no evidence of FXI being used in response to inflation developments, while there is strong evidence that FXI responds to exchange rates, indicating that IT central banks in EMDEs have dual inflation/exchange rate objectives. We also find a higher propensity to overshoot inflation targets in emerging market economies where FXI is more pervasive.

Do inflation-targeting central banks adjust inflation targets to meet the target?

Under inflation targeting, central banks are supposed to set an inflation target in advance and then try to make the actual inflation reach the target. However, central banks may have an incentive to adjust their targets to meet their goals. Panel data analysis with a sample of 19 inflation-targeting countries show that changes in the inflation target significantly and positively respond to the deviation of the inflation rate from the target in the previous period. This result supports the idea that inflation-targeting central banks adjust the inflation target to meet the target when they miss it. Further analysis suggests that such a relationship is more evident in central banks with low credibility or weak performance compared with high credibility or strong performance. Finally, we show that such behavior of central banks can lead to equilibrium indeterminacy in the standard New Keynesian model. Further, such behavior renders achieving equilibrium determinacy harder for central banks even in more realistic models. This result may imply that when central banks respond to missed inflation targets by adjusting their targets and to enhance the credibility and stabilize the inflation rate, they may end up destabilizing inflation expectations and the inflation rate.

Monetary Policy, Income Inequality, and Inflation — What’s the Link?

This paper studies the link in Canada between monetary policy, income inequality, and inflation. What are the effects of monetary policy on income inequality? and why and how does inflation play a role? Income inequality largely increased from the time the Bank of Canada began targeting inflation, through the late 1990s to the early 2000s, and flattened or decreased after the 2008 financial crisis. On the whole, income inequality today is greater than it was when the Bank of Canada became an inflation-targeting central bank. Against this backdrop, our analysis shows that expansionary monetary policy shocks, triggered by a lower than expected bank rate, lead to increasing income inequality, while contractionary monetary policy shocks reduce income inequality. We then show that these effects are asymmetric with expansionary shocks having a greater impact on income inequality than contractionary shocks. Expansionary monetary policy shocks result in a higher share of national income shifting to higher income households, who consume less as a percentage of their income, dampening the increase in aggregate demand, and, therefore, inflation. Our results lead to one particularly important conclusion for monetary policy: namely, that the Bank of Canada needs to account for the impact of income inequality when modeling how inflation will respond to a change in the overnight rate.

Intervention Under Inflation Targeting--When Could It Make Sense?

We investigate the motives inflation-targeting central banks in emerging markets may have for intervening in foreign exchange markets and evaluate the case for such interventions based on the existing literature. Our findings suggest that the rationale for interventions depends on initial conditions and country-specific circumstances. The case is strongest in the presence of large currency mismatches or underdeveloped markets. While interventions can have benefits in the short-term, sustained over time they could entrench unfavorable initial conditions, though more work is needed to establish this empirically. A first effort to measure the cost of interventions to the credibility of policy frameworks suggests that the negative impact may be smaller than often assumed—at least for the set of more sophisticated inflation-targeting emerging-market central banks considered here.

Intervention Under Inflation Targeting--When Could It Make Sense?

We investigate the motives inflation-targeting central banks in emerging markets may have for intervening in foreign exchange markets and evaluate the case for such interventions based on the existing literature. Our findings suggest that the rationale for interventions depends on initial conditions and country-specific circumstances. The case is strongest in the presence of large currency mismatches or underdeveloped markets. While interventions can have benefits in the short-term, sustained over time they could entrench unfavorable initial conditions, though more work is needed to establish this empirically. A first effort to measure the cost of interventions to the credibility of policy frameworks suggests that the negative impact may be smaller than often assumed—at least for the set of more sophisticated inflation-targeting emerging-market central banks considered here.

On the Response of Inflation and Monetary Policy to an Immigration Shock

An immigration shock has an ambiguous effect on inflation. On one hand, aggregate consumption increases with a suddenly larger population; this “demand channel” creates inflationary pressures. On the other hand, the labor market becomes more slack as immigrants search for jobs, containing wage growth; this “labor supply channel” creates dis-inflationary pressures. The response of an inflation-targeting central bank to an immigration shock is, therefore, not obvious. We study these competing channels in a New Keynesian model of a small open economy with search frictions in the labor market. Our simulations are designed to characterize the possible response of inflation and monetary policy in Chile, a small open emerging country that has experienced a substantial immigration flow in recent years.

Intervention Under Inflation Targeting--When Could it Make Sense?

We investigate the motives inflation-targeting central banks in emerging markets may have for intervening in foreign exchange markets and evaluate the case for such interventions based on the existing literature. Our findings suggest that the rationale for interventions depends on initial conditions and country-specific circumstances. The case is strongest in the presence of large currency mismatches or underdeveloped markets. While interventions can have benefits in the short-term, sustained over time they could entrench unfavorable initial conditions, though more work is needed to establish this empirically. A first effort to measure the cost of interventions to the credibility of policy frameworks suggests that the negative impact may be smaller than often assumed—at least for the set of more sophisticated inflation-targeting emerging-market central banks considered here.