MACROECONOMIC POLICY THE DEFINITION OF INFLATION TARGETING

Transcription

1 EC307 EPUK - Macroeconomic Policy Jennifer Smih - Universiy of Warwick ECONOMIC POLICY IN THE UK MACROECONOMIC POLICY THE DEFINITION OF INFLATION TARGETING Summary Various possible definiions of an inflaion argeing regime are oulined. A model is presened o illusrae he forward-looking naure of inflaion argeing (inflaion forecas argeing). Reading Bernanke, Ben (004), The logic of moneary policy [also covers Taylor rules] hp:// Bernanke, Ben, Laubach, Thomas, Mishkin, Frederic, and Posen, Adam (999), Inflaion argeing: lessons from he inernaional experience, Princeon Universiy Press, chs.-3. Bofinger, Peer (00), Moneary Policy, sec.8.4. Haldane, Andrew (995), Inflaion Targes, Bank of England Quarerly Bullein, (Augus) King, Mervyn (996), How should cenral banks reduce inflaion? Concepual issues, Bank of England Quarerly Bullein, November, 434ff. King, Mervyn (997), "The Inflaion Targe Five Years On", hp:// King, Mervyn (000), Moneary policy: heory in pracice, hp:// King, Mervyn (004), Commens on Risk and uncerainy in moneary policy by Alan Greenspan, AEA Annual Conference, hp:// King, Mervyn (005), Moneary policy: pracice ahead of heory [also covers Taylor rules] hp:// Svensson, Lars (997), Inflaion forecas argeing: implemening and monioring inflaion arges, European Economic Review 4, -46. hp://

2 Jennifer Smih - Universiy of Warwick THE DEFINITION OF INFLATION TARGETING The definiion of inflaion argeing is in par conroversial. We discuss he definiions of Lars Svensson, he ECB, and Peer Bofinger, Ben Bernanke e al., and Mervyn King. Svensson (00, Inflaion argeing: should i be modeled as in insrumen rule or a argeing rule?, European Economic Review, 46, ) defines inflaion argeing in erms of 3 characerisics: () Numerical inflaion arge poin (wih/wihou olerance inerval, or range. Specific price index. Achievemen of inflaion arge = primary goal or moneary policy (here may be secondary objecives oo). No oher nominal anchor. () CB s inflaion forecas has prominen role, insrumen se so ha his forecas (condiional on he insrumen-seing) is consisen wih he arge. Bu oupu and oupu-gap forecass can influence policy oo. (3) High degree of ransparency and accounabiliy. CB is accounable for achieving he inflaion arge and provides explici and ransparen moneary policy repors presening forecass and explaining policy. An inflaion arge also involves an insiuional commimen: () Clear mandae for moneary policy o aim for low inflaion. () CB independence a leas in erms of insrumen; CB could also define wha low inflaion means. (3) CB accounabiliy for achieving mandae. The ECB defines inflaion argeing as a moneary policy sraegy aimed a mainaining price sabiliy by focusing on deviaions in published inflaion forecass from an announced inflaion arge. (European Cenral Bank (004, nd edn), The Moneary Policy of he ECB, ECB, p.3). They believe ha in an inflaion argeing regime, he inflaion forecas is cenral o policy making and presenaion: he CB communicae[s] moneary policy decisions in erms of a more or less mechanical reacion o deviaions in a forecas for a paricular measure of inflaion from a specific inflaion arge a a paricular horizon (p.56). The ECB believes ha inflaion argeing policy presenaion would be relaively simple (p.68). The ECB offers a criical analysis of inflaion argeing (pp.56-57): focusing enirely on a forecas inflaion figure does no provide an encompassing and reliable framework for idenifying he naure of hreas o price sabiliy, which is necessary as he appropriae moneary policy response generally depends on he sources of hese risks o price sabiliy as a minimum, i requires a deeper analysis of he underlying economic siuaion and behaviour han is capured in an inflaion forecas alone various aspecs of he exbook inflaion argeing approach such as he fixed horizon (e.g. wo years) of he forecas from which moneary policy decisions feed back are somewha arbirary i is difficul o inegrae he informaion relevan for moneary policy conained in moneary aggregaes ino inflaion forecass ha are based on convenional macroeconomic models relying on a single forecas would be unwise, given he considerable uncerainy relaing o he srucure of he euro area economy The ECB says i preferred o adop a diversified approach drawing on a variey of analyical mehodologies (p.57). We shall see more of his owards he end of his secion of he EPUK module. Bofinger (00) disinguishes beween he explici and implici rules of inflaion argeing:

3 3 Jennifer Smih - Universiy of Warwick explici rule: keep he condiional inflaion forecas for he arge horizon of wo years close o he arge implici rule: increase (decrease) ineres raes if he condiional forecas exceeds (undershoos) he arge The explici rule mirrors he mandae from he UK Chancellor o he Bank of England. The implici rule is a (more explici) feedback rule ha ells he Bank how i should ac. Again, he forecas is cenral. Bofinger differs from he ECB in his assessmen of he simpliciy of his regime: while his rule looks simple a firs sigh, i is very differen from a fas and frugal heurisic (p.57). He describes inflaion argeing as like a cookery book ha, insead of providing concree recipes, only conains picures of he prepared dishes and he advice o buy he bes ingrediens and prepare hem as skilfully as possible. (p.65). His grounds for believing ha inflaion argeing should no be characerised as a simple rule, bu as a framework, are very similar o hose of Bernanke e al. s (999). Bernanke e al. s (999) definiion of inflaion argeing: Inflaion argeing is a framework for moneary policy characerised by he public announcemen of official quaniaive arges (or arge ranges) for he inflaion rae over one or more ime horizons, and by explici acknowledgemen ha low, sable inflaion is moneary policy s primary long-run goal. Among oher imporan feaures of inflaion argeing are vigorous effors o communicae wih he public abou plans and objecives of moneary auhoriies, and in many cases, mechanisms ha srenghen he cenral bank s accounabiliy for aaining hose objecives (p.4) Noe ha his definiion does no menion forecasing. Bernanke e al. are vague as o he role of explici inflaion forecasing in an inflaion argeing regime. I is worh noing ha he Bank of Canada and he Bank of Ausralia are widely regarded as (and regard hemselves as) inflaion argeers, alhough hey have provided only non-echnical forecass ha hardly differ from saemens ha can be found in ECB publicaions. Bu hese wo differ from he ECB (and he Bundesbank), who are classified by Bernanke e al. as hybrid inflaion argeers and moneary argeers, largely because of he emphasis placed by he ECB on moneary arges. Bernanke e al. believe ha inflaion argeing is bes characerised as a framework, no as a rule. They believe he rules-discreion disincion o be oo sharp o capure he realiy of moneary policy-making in pracice: here is no such hing in pracice as an absolue rule for moneary policy (p.5). They believe ha inflaion argeing has provided a framework ha is clearly ariculaed and in which he general objecives and acics of he policy-makers alhough no heir specific acions are commied o in advance (p.6). This hey erm consrained discreion. By imposing a concepual srucure and is inheren discipline on he cenral bank, bu wihou eliminaing all flexibiliy, inflaion argeing combines some of he advanages radiionally ascribed o rules wih hose ascribed o discreion (p.6). Why do Bernanke e al. hink inflaion argeing embodies discreion, and should no be characerised as a simple rule? A a echnical level, inflaion argeing does no provide simple, mechanical operaing insrucions o he cenral bank. Raher inflaion argeing requires he cenral bank o use srucural and judgmenal models of he economy, in conjuncion wih whaever informaion i deems relevan, o pursue is price-sabiliy objecive. In oher words, inflaion argeing is very much a look a everyhing sraegy, albei one wih a focussed goal. (p.). No specific se of variables nor specific model are prescribed by inflaion argeing. Mervyn King (004), in a response o a speech/paper by Alan Greenspan (Fed Chairman) on moneary policy, made some commens ha clarify how he (and he Bank) view inflaion argeing. In his 997 paper, King had argued ha any sensible regime could be wrien as an inflaion arge plus a response o supply shocks. In oher words, moneary policy should aim o mainain he opimal inflaion rae, and should decide how quickly o ge back o arge afer shocks. This characerisaion underlies many of he models we will see (e.g. Haldane-Salmon (996) algebra see Alernaives noes; and Svensson

4 4 Jennifer Smih - Universiy of Warwick (997) model o some exen see below). The consrained discreion ha characerises such a regime allows a cenral bank o ge (close) o he opimal sae coningen rule (King (004), p.5). King (004) argues ha his is consisen wih Greenspan s view ha he acual behaviour of CBs doesn vary much, wheher or no hey have an explici inflaion arge. King (004) defines he difference ha an inflaion arge makes as follows. The arge: embodies willingness o be explici abou he long-run inflaion rae ha consiues price sabiliy helps esablish poliical legiimacy necessary when he CB is independen helps ransparency and accounabiliy makes i easier o manage inflaion expecaions. King (004) also defines wha feaures mus be common o CBs: lags in ransmission mechanism necessiae forward-looking policy his means ha policy requires a forecas. [This is clearly conenious. King ries o idenify such a forecas wih non-economeric approaches by arguing ha a forecas is abou probabiliies, no poin esimaes. The key o communicaing policy is o explain he naure of he risks o he oulook for inflaion and oupu (p.6).] policy is pre-empive and involves managing risks he policy reacion funcion will change over ime King (005, secion 3) also defines an inflaion argeing framework as consiuing a precise numerical arge for inflaion in he medium erm a response o economic shocks in he shor erm. Emphasising he imporance of expecaions, King (005) remarks ha he inflaion arge provides a rulelike framework on which he privae secor can anchor is expecaions abou fuure inflaion (p.3). Explaining he phrase consrained discreion, he argues ha he discreion in responding o shocks afforded by inflaion argeing allows he cenral bank o adap is sraegy o new informaion he grea aracion of an inflaion arge is ha i is a framework ha does no have o be changed each ime we learn abou aspecs of he economy such as he velociy of money or he underlying rae of produciviy growh, as was he case in he pas wih frameworks based on arges for money aggregaes or nominal GDP growh. I is a framework designed for a world of learning (p.4). King (005) also emphasises he imporance of ransparency o inflaion argeing: he erms inflaion argeing a framework for making and communicaing decisions (p.4), and noes hree implicaions for communicaions: focuses aenion on case for price sabiliy (mus be made all he ime) forecas mus be accompanied by explanaion of MPC s hinking, as he MPC s underlying model [King s invered commas] changes coninuously no poin in communicaing ime-invarian policy reacion funcion: i doesn exis.

5 EC307 EPUK - Macroeconomic Policy Jennifer Smih - Universiy of Warwick Alernaive definiions of inflaion argeing Crierion Svensson (997,00) ECB (00) Bofinger (00) Bernanke e al. (999) King (004) Price sabiliy is main Yes Yes Yes Yes Yes arge of moneary policy Announcemen of Yes Yes Yes Yes Yes numerical arge Medium-erm arge Yes Yes Yes Unclear could have Yes more han one horizon Inensive Yes Yes simple Yes bu difficul Yes Yes communicaion wih public Specific moneary policy rule Inflaion forecas argeing Inflaion forecas argeing Explici + implici rules Unclear Inflaion arge + response o supply shocks Published forecass Inflaion and oupu Inflaion Inflaion and possibly oupu No required Unclear Goal dependence Yes No required No desirable Desirable No required Insrumen Yes Yes Yes Yes Yes independence Rule or discreion Source: Parly based on Bofinger (00), p.59 Rule Mechanical rule Appears simple, bu no. Comes close o pure discreion. Consrained discreion. Consrained discreion.

6 EC307 EPUK - Macroeconomic Policy Jennifer Smih - Universiy of Warwick A model of inflaion argeing as inflaion forecas argeing Lars Svensson, European Economic Review 997 argued ha inflaion argeing implies inflaion forecas argeing. This has implicaions for he specificaion of an inflaion arge and how moneary policy should operae o achieve he arge. Final arge = inflaion - has o be fuure inflaion because of moneary policy lags The CB s inflaion forecas becomes an inermediae arge - an ideal inermediae arge? inflaion forecas = he curren variable ha is mos correlaed wih he goal. By definiion i minimises he variance of he forecas errors and uses all relevan informaion. Bu i is correc only o he exen ha he CB s model is correc. if money growh / exchange rae argeing were opimal, hese would auomaically be implied by inflaion argeing. Svensson: forecas = more conrollable han he final goal. The insrumen has he same effec on acual and forecas inflaion. By definiion he forecas is more conrollable because is variance does no include he forecas errors. Svensson: forecas can be made more [publicly] observable han he [final] goal (p.3). Obviously you can observe he forecas now whereas you have o wai years o observe he relevan acual inflaion. forecas can be made ransparen, can help expecaions and credibiliy. The principles of inflaion argeing he operaion of he arge and he expeced acion of he CB once he forecas is known are very simple, which aids monioring. Svensson does however admi ha he consrucion of he forecas is difficul and resource-demanding (p.5) Svensson s (997) model (simplified by removing an exogenous variable x which migh affec inflaion and oupu direcly): + = + αy + ε + () y+ = β y + β ( i ) + η+ () where is inflaion, y is an endogenous variable (oupu, relaive o he naural oupu level which is normalised o zero), i is he moneary policy insrumen, α > 0; 0 β < ; β < 0; ε, η are iid shocks. (): he rae of change of inflaion is increasing in las year s oupu (): oupu is serially correlaed and increasing in las year s real repo rae The moneary policy insrumen i affecs oupu wih a -year lag and inflaion wih a -year lag: he conrol lag in his model is years. CB wans o se he insrumen { i τ } o minimise he expeced loss τ E δ L( τ ), where τ= τ = L ( τ ) = ( τ *). CB wishes o minimise he expeced sum of discouned squared fuure deviaions of inflaion from he arge. i affecs +, + 3,... ; i + affecs + 3, + 4,... ; and so on. So we can find he soluion o he CB s opimizaion problem by seing he insrumen a o hi he arge in +, and he insrumen nex period o hi he arge in +3, ec. So he opimal insrumen in period is given

7 7 Jennifer Smih - Universiy of Warwick by min Eδ L( + ), which clearly involves choosing i such ha E + = *. This las i expression is a rearranged f.o.c. for he opimizaion problem. The currenly-expeced (i.e. he curren forecas for he) one-o-wo year inflaion rae should be se equal o he inflaion arge. By subsiuion, + = a + a y + a3i + ( ε + + αη + + ε + ) (4) where a = α β, a = α( + β), a3 = αβ And obviously E + = a + a y + a3i. (5) Acual inflaion will deviae from he arge by he forecas error + *[ = + E + ] = ε + + αη + + ε + ; (6) hese are disurbances ha occur wihin he conrol lag, which he CB can do nohing abou. A bes he CB can conrol deviaions of -year forecas (raher han acual) inflaion from he arge. Arguably, herefore, he CB should be held accounable for he deviaions of forecas inflaion from he arge, raher han deviaions of acual (realised) inflaion from arge. This requires ha he CB s forecas be observable and verifiable. Seing he inflaion forecas (5) equal o he inflaion arge gives he CB s opimal reacion funcion i = ( * a a y ) a3 a a = ( *) y a a a 3 αβ = α β 3 α( + β) ( *) y α β α β 3 = + b ( *) + b y (7) + β where b =, b =. αβ β Since we assumed α > 0, 0 β <, and β < 0, his implies b > 0 and b > 0. Thus he ineres rae should be se equal o he inflaion rae, and should reac posiively o deviaions of curren inflaion above arge and posiively o deviaions of curren oupu above he naural rae. I is imporan ha he insrumen depends on he curren inflaion rae no because curren inflaion is argeed, bu because curren inflaion and oher variables in (6) influence (and hence forecas) fuure inflaion. If he CB follows his reacion funcion, he one-o-wo year inflaion forecas will equal he arge, and realised inflaion will deviae from he arge as a resul of he unpredicable shocks in (5). Wha if he CB cares abou growh oo? Specifically, say he CB wans o sabilise oupu around is naural rae as well as sabilising inflaion around arge. This will modify he period loss funcion as follows: L(, y ) = [( *) + λy ]

8 8 Jennifer Smih - Universiy of Warwick where λ > 0 is he relaive weigh placed on oupu sabilisaion. Eliminaing he exogenous variable for simpliciy from he above gives he reduced model: + = + αy + ε + ( ) y β y + β i η ( ) + = ( ) + + The f.o.c. for minimising he ineremporal loss funcion τ δ L( τ, yτ ) τ = E can be wrien E λ E y + * = + δαk λ( δ ) λ( δ ) 4λ where k is given by k = ( + ( + ) + ). δα δα α The -o- year inflaion forecas should equal he arge only if he 0-o- year oupu forecas equals he naural rae. Oherwise, inflaion should be allowed o exceed he arge in proporion o how much he oupu forecas falls shor of he naural rae. The degree of proporionaliy λ is increasing in he weigh he CB places on oupu sabilisaion λ and decreasing in he δα k shor-run inflaion-oupu rade-off α. The model has implicaions for he opimal speed of adjusmen of (forecas) inflaion o arge. When here is a posiive weigh on oupu sabilisaion, he CB should le inflaion reurn gradually o he (long-run) arge. Adjusing he forecas all he way immediaely would require greaer oupu flucuaions. Obviously, he less he CB desires oupu flucuaions, he slower should be he adjusmen of inflaion o arge. An implici rule for ineres-rae seing can be derived, in he same way as for he case where he CB didn care abou oupu: αδk + β i = ( E ( + ) *) y βλ β Bu now he CB has o respond o deviaions of he wo-year-ahead forecas from arge (whereas if i places no weigh on oupu i should respond o deviaions of curren inflaion from arge). As before, he coefficiens are posiive (since β <0), so expeced inflaion above arge and a posiive oupu gap boh imply higher ineres raes. Summary There are unpredicable shocks hiing inflaion afer he las ime a which he moneary policy insrumen (he ineres rae) can affec inflaion. Moneary policy canno counerac hese shocks. Acual inflaion will deviae from he arge, even if moneary policy is se opimally, as a resul of hese shocks. I would be unfair o judge he cenral bank on acual inflaion performance compared o he arge o he exen ha here are hese shocks. Insead, we could judge he CB on how is forecas compares wih he arge. The forecas should be made over he period in which moneary policy can no longer counerac shocks o inflaion. If he forecasing model is correc, he only hings ha will move acual inflaion away from he forecas (and also from he arge since, ideally, forecas=arge) are he unpredicable shocks occuring during he forecas horizon.

9 9 Jennifer Smih - Universiy of Warwick When he CB cares abou oupu as well as inflaion, he rae a which inflaion adjuss owards arge should be proporional o he weigh on oupu sabilisaion in he CB s loss funcion. zero weigh on oupu implies seing insrumen so ha inflaion forecas for he conrol lag always = arge greaer posiive weigh on oupu implies slower adjusmen of forecas owards arge (more / longer deviaions of forecas from arge allowed) Finally, i is worh quoing Svensson (004, Asse prices and ECB moneary policy, pp-) a lengh on his definiion of he principles and assessmen of he pracice of good moneary policy: So, he principles of good moneary policy are simple: perform flexible inflaion argeing, which means aiming o sabilize inflaion around an explici low posiive numerical inflaion arge wih some weigh also on sabilizing he real economy, which can be expressed more precisely as sabilizing he oupu gap, ha is, sabilizing oupu around a measure of poenial oupu. Because of he lags beween moneary-policy acions and he effec on inflaion and oupu, he bes way o do his is o look forward and perform forecas argeing. This means seing he cenral bank s insrumen rae (more precisely, o choose an insrumen-rae plan, a pah for he curren and fuure insrumen rae) such ha he corresponding inflaion and oupu gap forecass look good, which in urn means ha he inflaion and oupu gap forecass approach he inflaion arge and zero, respecively, normally some -3 years ahead (bu, more precisely, he whole fuure forecas pahs should look good, no jus he forecas a some fixed horizon). Alhough hese principles are simple he pracice of consrucing forecass, deciding on he appropriae insrumen rae (plan), and communicaing hese o he general public and he marke is quie complicaed and difficul.