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

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

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

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

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

percent 20 Real GDP growth rate (Quarterly) 15 10 5 -5 -10 60 65 70 75 80 85 90 95

percent 4 2 -2 GDP gap with HP trend for potential GDP -4 -6 60 65 70 75 80 85 90 95

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?

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

Smoothed inflation rate (4 quarter average) 8 12 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 60 65 70 75 80 85 90

Many other Experiences Inflation/Output Stability Before and After Inflation Targeting (percent) Source: Cecchetti and Ehrmann(1999) Period inf growth Before:1985-89 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.

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

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

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

- improved economic climate - increased inflation risks. On November 4, the European Central Bank raised the overnight rate by 50 basis points from 2.5 to 3.0 percent. Rationale: - improved economic climate - increased inflation risks.        Source: www.dglux.lu/en/505.htm

- Increased inflation forecast - Stronger economy On November 12, the Swedish Riksbank raised the overnight rate 35 basis points from 2.9% to 3.25%. Rationale: - Increased inflation forecast - Stronger economy        Source:www.dglux.lu/en/505.htm

On November 3, the Reserve Bank of Australia raised the overnight rate 25 basis points to 5% on 3 November, Rationale: - Inflation concerns - Strong economy        Source: www.dglux.lu/en/505.htm

- Inflation increasing.        On January 19, the Reserve Bank of New Zealand raised the overnight rate 25 basis points to 5.25%. Rationale: - Inflation increasing. Source: www.dglux.lu/en/505.htm

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

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

Inflation Forecast Based Rules it = g(Ett+j) for some j where E is the forecast Model or judgemental Can’t 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 j>2 there is great uncertainty Not as robust as rules with j = 0 and output gap

Inflation forecast targeting Set it so that Ett+j equals * or approaches it gradually over the time Much less formal research on this procedure not a rule hard to simulate Woodford’s 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

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

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).

Simulation results with exchange rate

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

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))

The Downward Spiral Problem Interest rate Constant Real Interest Rate Policy Rule Inflation rate Target The Downward Spiral Problem

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...

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”