Inflation Targeting and Monetary Policy Rules: Experience and Research

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Inflation Targeting and Monetary Policy Rules
Experience and Research

• John B. Taylor
• Stanford University
• Presented at the 12th Meeting of the Latin
  American Network of Central Banks and Finance
  Ministries
• Inter-American Development Bank
• May12, 2000

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Outline

• Conceptual Issues
• Recent experience in U.S. and other countries
• Describing the decisions as policy rules
• Research methodology
• Research results
• Key threshold for response to inflation
• Robustness
• Inflation forecast based rules and forecast
  targeting
• Exchange rates
• Gap uncertainty
• Asset price bubbles
• Zero interest bounds
• Conclusions

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Inflation targeting

• Choose an inflation target ?
• Explicit? Numerical? Implicit?
• Keep inflation rate close to the target
• In mathematical terms minimize, over a long
  horizon, the loss function
• w1(?t - ?)2 w2 (yt yt)2 w3 (et et)2
• Does not imply that w2 0, sometimes called
  strict
• Does imply that y natural rate of output

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But inflation targeting is not enough, need to
say something about the policy instruments

• Analogy
• Targeting the destination for a sailboat versus
  saying how to sail the boat to the destination in
  a short time
• angle of attack, sail trim, contingency for wind
  change,
• Many alternatives to achieve an inflation target
  
• Fixed money growth
• Permanently fixed exchange rate
• Active crawling peg
• Interest rate rule
• Exchange rate rule
• Monetary conditions index rule

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Recent Experience U.S.

• 2000 will be 18th year of the Long Boom
• First and second longest peacetime expansions in
  U.S. history
• 1991- , 1982-1990
• Recession in between was short and mild
• Inflation has been low and stable
• No period of macroeconomic stability like this
  before
• 17 years before this (1966-82) had 5 recessions
• Before 1982 in recession 35 percent of the time
• Since 1982 in recession less than 4 percent of
  the time

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percent
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Real GDP growth rate (Quarterly)
15
10
5
0
-5
-10
60
65
70
75
80
85
90
95
7
percent
4
2
0
-2
GDP gap with HP trend
for potential GDP
-4
-6
60
65
70
75
80
85
90
95
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Why the Increased Stability?

• Good luck?
• No big shocks like the 1970s?
• But shocks were big several times
• Late 1980s credit crunch
• 1998 currency crises,
• Now viewed as favorable supply shocks
• Change in the economic structure?
• Services, inventories, high-tech new economy
• Good policy?
• Fiscal policy?
• Deficit reduction and elimination?
• Keynesian counter-cyclical policy?

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U.S. monetary policy has changed

• More reactive to changes in inflation
• federal funds rate rises by twice as much when
  inflation rises 75 versus 150 basis points
• This more prompt, more reactive policy, has kept
  inflation from rising, thereby preventing
  recessions.
• For example, compare the funds rate changes in
  the late 1980s and the late 1960s

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Inflation rate
10
Smoothed inflation rate (4 quarter average)
8
6
1968.1 Funds rate was 4.8
1989.2 Funds rate was 9.7
4
2
0
60
65
70
75
80
85
90
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Many other Experiences Inflation/Output Stability
Before and After Inflation Targeting
(percent)Source Cecchetti and Ehrmann(1999)
Period ?inf ?growth
Before1985-89 15.0 7.5
After 1993-97 3.3 6.9
Difference 11.7 0.6
Australia Canada Chile Finland Israel New
Zealand Spain Sweden U.K.
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Describing Decisions for Policy Evaluation
Purposes

• Change overnight rate if
• (1) Inflation moves away from target
• (2) Real GDP moves away from trend (potential)
• Little mention of money growth or exchange rates
• Decisions are pretty well described by Taylor
  rule
• Interest rate inflation .5(inflation 2)
  .5(GDP gap) 2

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Use of Policy Rules in Practice

• Of course, no policy rule can be followed
  mechanically
• Special factors
• Need to estimate potential GDP growth
• But can be used as a guideline in many cases
• Or, more complex actions are approximated by a
  simple rule.
• Example, inflation forecast targeting
• Useful for private sector too

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Example Interest Rate Analysis of U.K.by
PriceWaterhouseCoopers

• If growth was left unchecked it could lead to an
  acceleration of inflation to over 4 in 2001.
  Using a simple Taylor rule, we estimate that
  interest rates would eventually need to be raised
  to around 7.5 by early 2001
• In contrast, if the UK recovery stalls next year
  then inflation is likely to fall further below
  target. Our Taylor rule simulations suggest that
  interest rates might then need to be cut to only
  around 4 by early 2001

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Source www.dglux.lu/en/505.htm
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Sourcewww.dglux.lu/en/505.htm
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Source www.dglux.lu/en/505.htm
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Source www.dglux.lu/en/505.htm
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Methodology for Research on Monetary Policy Rules

• Stick a policy rule into a model
• Having models at the central bank is important
• eg Brazil, Canada, Sweden, U.S.
• Solve the model
• Look at the behavior of the variables (inflation,
  real output, exchange rate)
• Choose the rule that gives the most satisfactory
  performance (optimal)
• Check for robustness using other models

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Interest rate
Constant Real Interest Rate
Policy Rule
Inflation rate
Target
Important Threshold Result Slope Should be
Greater 1
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Inflation Forecast Based Rules

• it g?(Et?tj) for some j where E is the
  forecast
• Model or judgemental
• Cant see future so based on current and lagged
  info
• A way to put weight on output Choosing a longer
  horizon (j) is like putting more weight on
  output.
• For j 6 not as good as simple rules in ECB
  simulations (Taylor, 1999)
• Optimal choice of j appears to be very small, and
  too large a j is not robust ( paper by Levin,
  Weiland, Williams presented at ECB conf.)
• For jgt2 there is great uncertainty
• Not as robust as rules with j 0 and output gap

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Inflation forecast targeting

• Set it so that Et?tj equals ? or approaches it
  gradually over the time
• Much less formal research on this procedure
• not a rule
• hard to simulate
• Woodfords Jackson Hole comment
• But in practice there is a role for forecasting
• Both inflation and real GDP growth
• Forecasting model at central bank needs to imbed
  threshold result
• Inflation Reports as in U.K. and Brazil are useful

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Exchange rate regimes

• Flexible exchange rates cum monetary policy rules
• Several models in research studies have the
  exchange rate channel as part of the transmission
  mechanism and perfect capital mobility
• But rule without exchange rate is still pretty
  robust
• My suggestion for a rule for the U.S. was based
  on a multicountry model with exchange rate
  channel
• But much more research is needed
• Exchange rate variations are more costly in small
  open economy with foreign currency denominated
  debt
• Using exchange rate to affect inflation directly

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Put exchange rate in policy rule
One approach Place exchange rate into interest
rate rule   it g??t gyyt ge0et ge1et-1
?it-1   where it is the nominal
interest rate, ?t is the inflation rate
(smoothed over four quarters), yt is the
deviation of real GDP from potential GDP, et is
the exchange rate (higher e is an appreciation).
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Simulation results with exchange rate
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Uncertainty in Measuring Potential GDP

• Uncertainty is very large
• Gap range is now 0 to 3 for U.S.
• Solutions
• Add research funds to get better estimates
• Reduce weight on gap (Frank Smets ECB study)
• Use growth rate rather than gap big debate here

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Interest rate hitting zero problem

• Downward spiral
• To estimate likelihood of hitting zero and
  getting stuck, put simple policy rule in policy
  model and see what happens
• pretty safe for inflation targets of 1 to 2
  percent
• Modify simple rule
• Interest rate stays near zero after the expected
  crises (Reifschneider and Williams (1999))

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Interest rate
Constant Real Interest Rate
Policy Rule
Inflation rate
0
Target
The Downward Spiral Problem
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Should central banks try to break stock price
bubbles?

• Add a stock price term to simple policy rule
• simulations show that reacting to this term
  increases output and inflation variability
• But some sharp changes in asset prices may
  require discretionary increases in liquidity
• 1987 stock market crash in U.S.
• 1998 reaction to change in risk premium...

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Conclusion

• Inflation targeting is not enough
• Implementing inflation targeting in practice
  requires analysis of how the instruments of
  policy should be changed
• Interest rate policy rules are a way to implement
  inflation targeting
• Lots of research about the form of policy rules
• Research needed on how policy rules are to be
  used
• Guidelines? Part of IMF programs? Private sector
  monitoring?
• More research is needed on exchange rate issues
  in highly open economies
• Flexible exchange rates with a monetary policy
  rules provide a lot of room between the corner
  solutions