Inflation-targeting Central Banks Research Articles

Monetary Policy and Uncertainty about the Natural Unemployment Rate

Inflation-targeting central banks have only imperfect knowledge about the effect of policy decisions on inflation. An important source of uncertainty is the relationship between inflation and unemployment. This paper studies the optimal monetary policy in the presence of uncertainty about the natural unemployment rate, the short-run inflation-unemployment tradeoff and the degree of inflation persistence in a simple macroeconomic model, which incorporates rational learning by the central bank as well as private sector agents. Two conflicting motives drive the optimal policy. In the static version of the model, uncertainty provides a motive for the policymaker to move more cautiously than she would if she knew the true parameters. In the dynamic version, uncertainty also motivates an element of experimentation in policy. I find that the optimal policy that balances the cautionary and activist motives typically exhibits gradualism, that is, it still remains less aggressive than a policy that disregards parameter uncertainty. Exceptions occur when uncertainty is very high and in inflation close to target.

Monetary Policy Rules in Practice: Evidence from New Zealand

We use the ten years of experience in inflation-targeting in New Zealand since 1989 to test whether monetary policy appears to conform to the simple rules that have been recommended for it in the literature. Of the inflation targeting central banks, the Reserve Bank of New Zealand has both the longest experience and probably the most clearly defined target and policy framework for achieving it. We show that while a Taylor rule with the standard parameters used in the US does indeed describe New Zealand monetary policy quite well, the Reserve Bank has focused rather more strongly on price stability, as required by its Policy Target Agreements. However, while the conduct of New Zealand monetary policy as set out in the Monetary Policy Statements is firmly based on targeting the inflation rate in the future we find, using the Bank's own forecasts, that nevertheless targeting inflation close to the present appears to be a better description of policy. Furthermore, restricting the policy choice to the information available to the Reserve Bank at the actual time of policy settings and ignoring subsequent revisions to published statistics does not result in a much improved explanation of its actions. We find a clear 'smoothing' element to the Bank's policy rather than immediate response to every small fluctuation. We show further that some of the variables that enter the policy rule have slightly asymmetric cycles. From symmetric and asymmetric cointegration tests on the long-run relationship between interest rates, the output gap, and inflation we show that there is insufficient evidence to suggest that monetary policy has been asymmetric in treating upside inflationary pressures differently from those towards deflation.

Targeting inflation over the short, medium and long term

An inflation targeting central bank aims to stabilize the rate of inflation. But which ‘inflation’ should this be? Quarterly, annual, biennial? We analyze the effects on optimal monetary policy of increasing the period over which the inflation rate is defined. When inflation stabilization is the sole objective of the central bank, more aggressive monetary policy results; but when output stabilization is also a concern the result is a more cautious conduct of monetary policy and less variability in output. Thus, there is an observational equivalence between increasing the period over which inflation is measured and increasing the weight on output stabilization in the central bank’s objective function. The analogy between inflation targeting with an infinite-period target and price level targeting is also examined.

Should Central Banks Respond to Movements in Asset Prices?

In recent decades, asset booms and busts have been important factors in macroeconomic fluctuations in both industrial and developing countries. In light of this experience, how, if at all, should central bankers respond to asset price volatility? We have addressed this issue in previous work (Bernanke and Gertler, 1999). The context of our earlier study was the relatively new, but increasingly popular, monetary-policy framework known as inflation-targeting (see e.g., Bernanke and Frederic Mishkin, 1997). In an inflation-targeting framework, publicly announced medium-term inflation targets provide a nominal anchor for monetary policy, while allowing the central bank some flexibility to help stabilize the real economy in the short run. The inflation-targeting approach gives a specific answer to the question of how central bankers should respond to asset prices: Changes in asset prices should affect monetary policy only to the extent that they affect the central bank’s forecast of inflation. To a first approximation, once the predictive content of asset prices for inflation has been accounted for, there should be no additional response of monetary policy to assetprice fluctuations. In use now for about a decade, inflationtargeting has generally performed well in practice. However, so far this approach has not often been stress-tested by large swings in asset prices. Our earlier research employed simulations of a small, calibrated macroeconomic model to examine how an inflation-targeting policy (defined as one in which the central bank’s instrument interest rate responds primarily to changes in expected inflation) might fare in the face of a boom-and-bust cycle in asset prices. We found that an aggressive inflationtargeting policy rule (in our simulations, one in which the coefficient relating the instrument interest rate to expected inflation is 2.0) substantially stabilizes both output and inflation in scenarios in which a bubble in stock prices develops and then collapses, as well as in scenarios in which technology shocks drive stock prices. Intuitively, inflation-targeting central banks automatically accommodate productivity gains that lift stock prices, while offsetting purely speculative increases or decreases in stock values whose primary effects are through aggregate demand. Conditional on a strong policy response to expected inflation, we found little if any additional gains from allowing an independent response of central-bank policy to the level of asset prices. In our view, there are good reasons, outside of our formal model, to worry about attempts by central banks to influence asset prices, including the fact that (as history has shown) the effects of such attempts on market psychology are dangerously unpredictable. Hence, we concluded that inflationtargeting central banks need not respond to asset prices, except insofar as they affect the inflation forecast. In the spirit of recent work on robust control, the exercises in our earlier paper analyzed the performance of policy rules in worst-case † Discussants: Robert Shiller, Yale University; Glenn Rudebusch, Federal Reserve Bank of San Francisco; Kenneth Rogoff, Harvard University.