Open-Economy Inflation Targeting Tomáš Holub International Macroeconomics 3 May 2016

Outline MP regimes – some traditional alternatives Inflation targeting in theory Performance of inflation targeting Inflation targeting and the recent crisis Summary and conclusions

Some Alternatives of MP Regimes (with Floating ER) Refi rate Money market rates Econ. outlook Money supply Inflation (goal) Two pillars Repo rate Money market rates Inflation (goal+target) Infl. targeting Monetary transmission OMOs Monetary base Inflation (goal) Money targeting Money supply (target) Fed funds Money market rates Inflation, growth etc. (goals) Just do it Monetary transmission

Monetary Policy Regimes (i) Exchange rate pegs and multiple targets still quite numerous, but IT gaining increasing share. Source: IMF; Batini, et al. (2006)

Monetary Policy Regimes (ii) IT‘s share above 20% (around 32 countries now; i.e. still a minority in practice, but state-of-the art in theory before the crisis).

Monetary Policy Regimes (iii) Inflation targeting + ECB‘s 2-pillar strategy dominate for freely floating countries. But IT also most frequent for (managed) floating countries.

Advantages of Inflation Targeting Embodies all the modern trend in central banking: independence, rules, transparency and accountability; Combines a policy rule with discretion (flexible rule); The target and the ultimate goal are identical; Does not rely on stable money demand; Takes into account all available information; A direct emphasis put on market expectations; Strengthens internal discipline and forecasting of CB.

Theoretical Background Trying to reach both low inflation (primary goal – can be controlled by MP in the long run) and optimal stabilisation in the presence of (often unforeseen) shocks.

Closed-Economy Inflation Targeting Phillips Curve Aggregate Demand Policy rule Loss Function

Policy Rule under Inflation Targeting Strict Inflation Targeting: equate the forecast of inflation with your target at the horizon of transmission (Svensson: “inflation-forecast targeting”). Beware: no one actually does strict inflation targeting!

Policy Rule under Inflation Targeting Flexible Inflation Targeting: gradually return the forecast of inflation to target, taking into account the variability of output. In practice: setting the monetary policy horizon, choice of targeted index, escape clauses, IR smoothing, etc.

Open-Economy Inflation Targeting Phillips Curve Aggregate Demand Loss Function Exchange Rate

An unexpected domestic IR increase should lead to a jump appreciation, which creates expectations of future depreciation. In practice, the adjustment is often more gradual. UIP and the MP Transmission

Exchange Rate Transmission A richer set of transmission channels with different speeds. The exchange rate may also be a source of shocks.

… the lessons to draw from the empirical evidence are what might be described as “non-negative”. The contribution of inflation targeting to low and stable inflation among industrial countries is weak, but it also has not had negative effects on real activity. It does seem to have anchored inflation expectations. For the developing economies, inflation targeting has been associated with lower and more stable inflation and real activity. (Walsh, 2009) (for more on this, see the seminar) Performance of IT before the crisis

IT Performance in the Crisis Rose (2013) (ht ).ht Inflation targeting has proven quite durable – no one has left it except for the euro adoption.

IT Performance in the Crisis Rose (2013) Not much difference between IT and hard pegs (but better inflation performance than the other regimes). See also Irineu E. de Carvalho Filho (2011) – seminar topic.

When IT was being introduced, it was often criticised as too tight („inflation freaks“). Before the crisis, some people were saying that the IT alone is not enough, and that it might actually be too loose, thus „blowing with the wind“ (e.g. W. White, BIS). After the crisis broke out, this camp was joined by many others, but:  Was it due to IT per se?  Or was the MP too loose even by the IT standard (failure of implementation vs. failure of regime)? IT and the Recent Crisis

MP in Major Economies – Deviations from the Taylor Rule The MP was quite loose even by the traditional (IT) standards. Response to the dot.com bubble and September 11; too much focus on core inflation, output gap etc.? Source: IMF, WEO, April Source: Eurostat, CNB calculations.

Deviations from the Taylor Rule and Housing Booms Source: Ahrend, et al. (2008)

Now some people are actually once again suggesting that IT is too tight, and that central banks need to „commit to irresponsibility“ to overcome the ZLB / deflation threat. Price level targeting or nominal GDP level targeting have been suggested as alternatives. No country has actually adopted these regimes yet (just some temporary elements of it within the IT framework). Japan: has recently increased its inflation target to 2% to overcome deflation. IT and the Recent Crisis (cont.)

IT vs. Price Level Targeting Source: Böhm, et al. (2012)

Inflation targeting focused on building credibility and anchoring expectations (”constrained discretion“); IT has gained bigger ”market share“ among MP regimes; Strict vs. flexible inflation targeting (no one does the strict one); In open economies, the exchange rate is an important part of the transmission mechanisms, as well as a source of shocks; The performance seems to be good (or at least non-negative) so far; The current crisis has challenged the paradigm, but IT may survive it – with modifications – better than most other known alternatives (and PLT is so far a textbook debate). Conclusions

Thank you for your attention.

Some References Benecká, S. (2011): ”International reserves and the financial crisis: monetary policy matters,“ CNB mimeo. Benecká, S., Holub, T., Kadlčáková, N.L., and Kubicová, I. (2012): ” Does Central Bank Financial Strength Matter for Inflation? An Empirical Analysis“ CNB WP (forthcoming). BoC (2011): ”Renewal of the Inflation-Control Target: Background Information - November 2011“, Bank of Canada, Böhm, J., Filáček, J., Kubicová, I., and Zamazalová, R.(2012): ”Price-Level Targeting - A Real Alternative to Inflation Targeting?“ Czech Journal of Economics and Finance, vol. 62, no. 1, pp. 2-26, Gonçalves, C.E.S, and Salles, J.M. (2008): ”Inflation targeting in emerging economies: What do the data say?“ Journal of Development Economics, 85, pp. 312–318, IMF, Batini et al. (2006): ”Inflation Targeting and the IMF“, Irineu E. de Carvalho Filho (2011): ”28 Months Later: How Inflation Targeters Outperformed Their Peers in the Great Recession,” The B.E. Journal of Macroeconomics: Vol. 11: Iss. 1 (Topics), Article 22, Mishkin, F. S., Schmidt-Hebbel, K. (2006): “Does Inflation Targeting Make a Difference?“ CNB WP, no. 13/ Svensson, L. E. O. (1999a): “Inflation Targeting as a Monetary Policy Rule,” Journal of Monetary Economics, 43, pp. 607–654. Svensson, L. E. O. (1999b): “Price Level Targeting vs. Inflation Targeting: A Free Lunch?” Journal of Money, Credit and Banking, no. 31, pp. 277–295. Svensson, L. E. O. (2000): “Open-Economy Inflation Targeting”. London, CEPR Discussion Paper, no (October). Walsh, C.E. (2009): ”Inflation targeting: What have we learned?“ The John Kuszczak Memorial Lecture, prepared for "International Experience with the Conduct of Monetary Policy under Inflation Targeting," Bank of Canada, July 22-23, 2008,