Inflation Targeting Economies Research Articles

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.

Exchange rate pass-through and inflation targeting regime under energy price shocks

The global surge in energy costs poses a significant obstacle for the attainment of price stability by the central banks across the world. This obstacle is further magnified for the economies that adopt an inflation-targeting framework and a flexible exchange rate regime. To overcome this challenge, our study attempts to answer whether inflation targeting can achieve price stability if an exchange rate pass-through exists, especially in the presence of energy price shocks. The study uses secondary data from twenty-one inflation-targeting economies for the period 1997-2020 and applies the non-linear autoregressive distributive lag (NARDL) model to test the hypotheses empirically, considering the possible asymmetries. The results confirm that exchange rate depreciation increases domestic price levels, while exchange rate appreciation reduces them in the long run. The study also finds that rising energy prices contribute to higher inflation in inflation-targeting economies. These findings suggest that inflation-targeting economies face a serious challenge in maintaining their core price stability goal due to exchange rate pass-through especially during energy price shocks. The results invite authorities of IT economies to re-evaluate their policy framework that conveniently ignores exchange rate pass-through by requiring a mandatory floating exchange rate regime.

Assessing Monetary Policy via the Taylor Rule in a Selection of Middle-Income Emerging Market Economies: Issues and Evidence

Monetary policies have a history of changing over time as central banks seek frameworks that suit the current state of their economies. In this research, the objective was to re-examine the famous Taylor rule (augmented to include the exchange rate) and proceed to establish its validity in the wake of recent unconventional policy developments from the United States. The Taylor rule posits that interest rates respond to the deviation of inflation from a given target and the output gap. The study is limited to five emerging market economies namely Brazil, Chile, Mexico, South Africa, and Turkey which are all inflation targeting economies with quarterly data observed between 1998 and 2020. Overall, the variables exhibited a mixed order of integration which necessitated the use of the ARDL bounds testing procedure in the time series framework. The study also invoked the panel vector autoregression model with impulse response functions computed using the local projections method. The study observed two main results. First, there is evidence that interest rates respond to inflation dynamics and demand fluctuations both in the short-run and long-run in most of these countries as predicted by the Taylor rule. Second, there is evidence of a significant association between policy rates and the exchange rate.

Dynamics of Money Market Interest Rates in Ghana: Time‐Frequency Analysis of Volatility Spillovers

AbstractAs the second longest practicing inflation targeting economy in Africa, it is of interest to investigate the degree to which policy interest rate influences other money market rates so as to gauge the overall effectiveness of monetary policy transmission in Ghana. This study evaluates the degree of connectedness among money market rates and also determines the most dominant money market rate(s) in Ghana. The basic finding is that the monetary policy rate has a low‐to‐moderate influence on volatility dynamics of other money market rates in Ghana across historical time‐interval and time‐frequency domains. This is a reflection of a generally weak capability of policy interest rate to drive other market rates in Ghana. Both monetary policy rate and Treasury bill rate are net transmitters of shocks, while interbank, lending and saving rates are net receivers of shocks in the money market. However, the Treasury bill emerges as the largest shock transmitter in the money market, across all forecast horizons and analytical domains. The lending rate is the largest shock recipient in the money market, largely from the Treasury bill rate which suggests ample evidence of fiscal dominance in Ghana. The study accentuates the exigency for monetary and fiscal policies to expeditiously address the domestic structural bottlenecks, especially in the financial sector and the fragile fiscal profile, in order to strengthen policy transmission in Ghana.

Does Monetary Policy Credibility Help in Anchoring Inflation Expectations? Evidence from Six Inflation Targeting Emerging Economies

Abstract Most emerging market central banks have adopted inflation targeting as their monetary policy system. The heart of inflation targeting system is inflation expectations. The success of a central bank in achieving targets depends on to the extent to which inflation expectations are formed by the announced targets. As the credibility of the central bank increases, its ability to affect the public expectation also increases. The public adjusts its inflation expectations based on announced inflation target only in case of that they believe that the central bank has the sufficiency to reach the inflation target. Credibility enables expectation to be formed in a forward-looking way by weakening its connection with the past. This study aims to contribute to the literature concerning the effects of credibility on monetary policy. For this purpose, using data of six emerging inflation targeting economies (Turkey, Brazil, the Czech Republic, Chile, Poland, and South Africa), the empirical tests were carried out in order to understand the effect of the credibility on the behaviour of inflation expectation in emerging economies. The findings denote that credibility is quite relevant to reduce inflation expectations and contributes to the strength of inflation targets being an anchor for inflation expectations.

Words and deeds in managing expectations: Empirical evidence from an inflation targeting economy

Monetary policy affects private sector expectations through not only its actions, but also its communication. In this paper, we adopt a novel approach to compare the impact of central bank interest rate decisions, macroeconomic projections, and textual content of policy documents on private sector expectations. We demonstrate that the role of central bank communication and decisions differs depending on the variable and the forecast horizon. The reaction of inflation expectations to typical changes in policy communication is stronger than their responses to typical policy decisions, whereas the opposite holds for interest rate expectations. Our findings imply that central banks have a range of measures at their disposal to affect expectations. The ability to use communication in managing expectations is especially important when the scope of reducing interest rates is limited.

Openness-inflation Nexus in alternative monetary regimes

Abstract By applying an endogenous switching regression model to a sample of 64 countries, this article explores whether the effect of trade openness on inflation is influenced by the adoption of inflation targeting (IT). The outcome indicates that, while there exists a significant and negative impact of trade openness on inflation in the non-IT countries with flexible exchange rate system, the effect is negligible in the IT economies. In addition, the above differential inflation effect of trade openness across IT and non-IT regimes is only present in the developing subsample with flexible exchange rate system, but not the developed counterpart. Moreover, apart from trade openness, financial openness reinforces inflation in those developing countries not adopting IT, whereas no such significant effect is found in developing countries adopting IT. Instead of inflation, further results show that trade openness lowers inflation volatility both in developing and developed countries not adopting IT, yet the impact is smaller in developed country group. However, no such statistically significant link is found in developing and developed countries that adopt IT.

U.S. monetary policy and income inequality in small open economies

We examine the impact of changes in U.S. monetary policy stance on income inequality of open economies. Using a Heterogeneous Agents New Keynesian model with price and wage rigidities, we show that in an expansionary (contractionary) monetary shock by Fed increases (decreases) income inequality in open economies. This impact is much higher in inflation targeting regime than in pegged exchange rate regime. We also find that while the impact of U.S monetary shock on inequality in pegged exchange rate regime is critical function of wage rigidity in the economy, it is independent of wage rigidity in inflation targeting economies. Our analysis indicate that in presence of hand to mouth households, an increase in wage flexibility certainly reduces welfare in in a pegged exchange rate economies. Our empirical estimates confirm our model prediction. More precisely, the estimates produce robust evidence that 100 basis point increase in Fed Fund Rate lower income inequality in open economies by nearly 0.15% over two years.

The real effects of loan-to-value limits: empirical evidence from Korea

This study adds to a recent and growing literature that assesses the effects of macroprudential policy. We compare the effects of monetary policy and loan-to-value ratio shocks for Korea, an inflation-targeting economy and an active user of loan-to-value limits. We identify shocks using sign restricted structural VARs and rely on a recent approach within this method to conduct structural inference. This study finds that both monetary policy and loan-to-value ratio shocks have effects during the period that our sign restrictions applies on different measures of credit, i.e., real bank credit, real total credit and real household credit, as well as on real output, real consumption and real investment. We find though that loan-to-value ratio shocks have negligible effects on the price level. Both shocks, however, have non-negligible effects on real house prices, evidence that go beyond the period of the imposed sign restrictions. These findings indicate that for the period covered by this study, limits on loan-to-value achieved their financial stability objectives in Korea in terms of limiting credit and house price appreciation under an inflation-targeting regime. Furthermore, it attained these objectives without posing any threat to its price stability objective. Overall, these findings suggest that limits on loan-to-value have important aggregate consequences despite it being a sectoral, targeted policy instrument.

Do Capital Flows Matter for Monetary Policy Setting in Inflation Targeting Economies?

The aim of this study is to determine if capital flows can account for the international effects on domestic monetary policy, using an augmented Taylor rule model. In addition to the standard determinants of nominal interest rates, we include capital flow measures to show how central banks consider this important factor when deciding on the most appropriate monetary policy. Using a panel of inflation targeting economies and the dynamic panel approach, this study finds that capital inflows and outflows are an important determinant of nominal interest rates.

Exchange rate pass-through & management of inflation expectations in a small open inflation targeting economy

In the context of inflation targeting, this study analyses the exchange rate pass-through (ERPT) to inflation expectations in a small open inflation targeting economy. We also augment the inflation expectations function with GDP, inflation, unemployment, fiscal stance, oil prices and money supply. Drawing on the data from May 1999 to Dec 2018 on the Czech Republic, which was the first developing country to adopt inflation targeting, our key results suggest that ERPT has significant implications for inflation expectations. Inflation expectations are also strongly influenced by actual inflation and past inflation expectations suggesting evidence of adaptive expectations. Economic growth, labour market outlook, money supply, oil price shocks and fiscal stance also showed a considerable impact on inflation expectations, though results varied in the short and long run. Our study contributes to the debate on ERPT and inflation targeting by reflecting on the inflation expectations channel.

The Real Effects of Loan-To-Value Limits: Empirical Evidence from Korea

This study adds to a recent and growing literature that assesses the effects of macroprudential policy. We compare the effects of monetary policy and loan-to-value ratio shocks for Korea, an inflation targeting economy and an active user of loan-to-value limits. We identify shocks using sign-restricted structural VARs and rely on a recent approach within this method to conduct structural inference. This study finds that both monetary policy and loan-to-value ratio shocks have effects on different measures of credit, i.e., real bank credit, real total credit and real household credit. We also find that both shocks have non-negligible effects on real house prices, including effects on real output, real consumption and real investment. We do, however, find that loan-to-value ratio shocks have negligible effects on the price level. These findings indicate that for the period covered by this study, limits on loan-to-value achieved their financial stability objectives in Korea in terms of limiting credit and house price appreciation under an inflation targeting regime. Furthermore, it attained these objectives without posing any threat to its price stability objective. Overall, these findings suggest that limits on loan-to-value have important aggregate consequences despite it being a sectoral, targeted policy instrument.

Examining Structural Unemployment in Sub-Saharan Africa: Empirical Evidence from Unobserved Components

We apply multivariate filtering techniques to quantify structural unemployment (NAIRU), potential output, output gap and unemployment gap for South Africa, Kenya, Mauritius and Ghana. NAIRU estimates are especially relevant for these inflation-targeting or hybrid inflation-targeting economies, allowing them to assess level of domestic slack and any potential build-up of inflationary pressures. Our findings suggest that increased government spending on education, a competitive exchange rate, and boosting the level of financial development (measured as the market capitalization of listed companies) can play a role in lowering NAIRU in these Sub-Saharan African countries.

An Unconventional Approach to Evaluate the Bank of England’s Asset Purchase Program

Empirical papers analysing the transmission of (unconventional) monetary policy typically rely on a vector autoregressive framework. In this paper, I complement these studies and employ a matching approach to examine the impact of the Bank of England’s asset purchase program on macroeconomic quantities in the UK. My sample covers the period March 2001−December 2015 and five small open inflation targeting economies. Using entropy balancing, I create a synthetic control group comprised of credible counterfactuals for the sample of observations subject to quantitative easing (QE). My key results indicate that a 100 bn GBP increase in QE has a significant and positive effect on GDP growth with a peak effect of 0.66−0.69 percentage points (pp) after 30 months. The same increase leads to a reduction in the inflation gap with a peak effect between −0.77 and −0.94 pp after 30 months. An in-depth analysis reveals that the latter finding is not driven by the choice of the empirical methodology. In contrast, I find that the returns on QE in the UK are decreasing (i) over time and (ii) with the volume of QE. Consequently, monetary policymakers should be aware of the fact that the returns on QE might be non-linear and that QE eventually could have detrimental effects.

Exchange Rate Pass-Through & Management of Inflation Expectation in a Small Open Inflation Targeting Economy

This study analyses the aspect of inflation expectations management in the context of inflation targeting by particularly focusing on the impact of exchange rate pass-through to inflation expectations in a small open economy. We also augment the inflation expectations function with GDP, inflation, unemployment, fiscal stance, oil prices, and money supply. Drawing on the data from May 1999 to Dec 2018 on the Czech Republic which is the first developing country to adopted inflation targeting, our key results suggest that ERPT has significant implications for the inflation expectations. Inflation expectations are strongly influenced by the actual inflation and the past inflation expectations suggesting evidence of adaptive expectation. The economic growth, labour market outlook, money supply, oil price shocks, and fiscal stance also showed a considerable impact on inflation expectations, though results varied in the short and long-run. Our study contributes to the debate on ERPT and inflation targeting by reflecting on the inflation expectations channel.

Exchange rate interventions and inflation expectations in an inflation targeting Economy

We explore the impact of exchange rate interventions on inflation expectations and exchange rates in Chile. We consider two episodes of central bank interventions during the sample period 2007-2012. Our analysis indicate that interventions did have an impact on daily exchange rate returns. In terms of inflation expectations, we find that the intervention program carried out in 2008 had a significant, but relatively short-lived, impact on the distribution of inflation expectations at long horizons. In contrast, the intervention carried out in 2011 shows no relevant impact on the distribution of inflation expectations in Chile.

Effects of Monetary and Macroprudential Policies—Evidence from Four Inflation Targeting Economies

AbstractWe examine the effects of monetary and macroprudential policies in the Asia‐Pacific region, where many inflation targeting economies have adopted macroprudential policies in order to safeguard financial stability. Using structural panel vector autoregressions that identify both monetary and macroprudential policy actions, we show that tighter macroprudential policies used to contain credit growth also have a significant negative impact on macroeconomic aggregates such as real GDP and the price level. The similar effects of monetary and macroprudential policies may suggest a complementary use of the two policies at normal times. However, they could also create challenges for policymakers, especially during times when low inflation coincides with buoyant credit growth.

Exchange rates and monetary spillovers

When do flexible exchange rates prevent monetary and financial conditions from spilling over across currencies? We examine a model in which international investors strategically supply capital to a small inflation-targeting economy with flexible exchange rates. For some combination of parameters, the unique equilibrium exhibits the observed empirical feature of prolonged episodes of capital inflows and appreciation of the domestic currency, followed by reversals where capital outflows go hand-in-hand with currency depreciation, a rise in domestic interest rates, and inflationary pressure. Arbitrarily small shocks to global financial conditions suffice to trigger these dynamics.

A Quarter Century of Inflation Targeting & Exchange Rate Pass-Through: Evidence from the First Three Movers

This study has analysed the implications of Inflation Targeting for the Exchange Rate Pass-Through (ERPT) to inflation and trade balance. In this endeavour, we have focused on the first three movers i.e. New Zealand, UK and Canada. Drawing on the monthly data from October 1976 to September 2017, we employed a Time-Varying Structural Vector Auto-regressive framework in which the sources of time variation were both the coefficients and variance-covariance matrix of the innovations. Our key findings suggest that there is significant evidence of time-variation in the ERPT to inflation and trade balance in all three countries. In specific to inflation, the results showed that contrary to the notion that the ERPT to inflation has decreased in the Inflation Targeting economies, in fact, there is strong evidence that if there is anything, it is the other way around. The results using the ADF unit root test with a structural break (with innovation and additive outliers) suggested that the coefficients for inflation showed a decrease in oscillations which corresponded with the start of inflation targeting. However, this coincident cannot lead to infer that the ERPT has lost its significance. There is also a considerable amount of heterogeneity in the ERPT in the under-analysis countries. Specifically, in response to the positive Real Effective Exchange Rate (REER) shock, the inflation fell in the UK and New Zealand whereas, in Canada, it had the opposite effect. On the ERPT to the Trade Balance, the results on the UK showed a clear evidence of J-curve whereas in Canada, the impact was rather instantaneous and the trade balance quickly deteriorated. In New Zealand, the trade balance also showed deterioration in response to the REER shocks, although comparatively there was milder response than Canada and UK. Our findings have profound implications for monetary policy formulation under inflation targeting regimes and the influence of EPRT on price stability and external balance.

Managing price and financial stability objectives in inflation targeting economies in Asia and the Pacific

Many central banks have adopted explicit objectives for financial stability, raising the possibility of trade-offs between price and financial stability objectives. Based on structural vector autoregressions that incorporate both monetary and macroprudential policy shocks for four inflation targeting economies in Asia and the Pacific, we analyse the role of each policy shock in explaining deviations from the other policy’s objective, by applying historical decompositions. The macroprudential measures used in the study affect credit extended to the private sector. We find that there are periods when macroprudential policy shocks have contributed to pushing inflation away from the central bank’s inflation target and when monetary policy shocks have contributed to buoyant credit, suggesting that there have been short-term trade-offs between price and financial stability objectives. However, we also find periods when macroprudential policy shocks helped stabilise inflation and monetary policy shocks contributed to financial stability.