May 8th, 2008 Creeping Inflation: How much of a concern? What should the response be? XXVII Meeting of the Latin American Network of Central Banks and Finance Ministries Alberto Torres Banco de México

Outline 1. Real Food and Oil Price Changes 2.Implications for Monetary Policy 3.Additional Considerations

3 Commodity Price Indexes (Index Jan 2003 = 100) Source: IMF. 1. Real Food and Oil Price Changes

4 Real Food Price Changes (Annual % Change of Real Price) Source: IMF. Calculations by Banco de México. 1. Real Food and Oil Price Changes

Distribution of Real Food Price Changes (Annual % Change of Real Price) Jan.81-Nov.85Dec.85-Jan.97Feb.97-Dec.99Jan.00-Aug.02Sep.02-Mar.08 Source: IMF. Calculations by Banco de México.

6 Real Food Price Changes (Proportion of Time Above Threshold) 1. Real Food and Oil Price Changes Source: IMF. Calculations by Banco de México.

7 Real Food Price Changes (Mean Above Threshold) 1. Real Food and Oil Price Changes Source: IMF. Calculations by Banco de México.

8 Real Crude Oil Price Changes (Annual % Change of Real Price) Source: IMF. Calculations by Banco de México. 1. Real Food and Oil Price Changes

Jan.81-Jan.87Feb.87-Jul.91Aug.91-Mar.99 Abr.99-Mar.08 Distribution of Real Crude Oil Price Changes (Annual % Change of Real Price) Source: IMF. Calculations by Banco de México.

10 1. Real Food and Oil Price Changes Food (Annual % Change of Real Price) Crude Oil (Annual % Change of Real Price)

Outline 1. Real Food and Oil Price Changes 2.Implications for Monetary Policy 3.Additional Considerations

12 As is well-known in the economic literature (e.g. Clarida, Gali and Gertler, 1999; Walsh, 2003; Woodford, 2003; and others) the optimal monetary policy response to any shock is the solution to a problem where: The policy maker minimizes a quadratic loss function that reflects society’s preferences for inflation and output stabilization. This optimization is made subject to the structure of the economy, which is typically assumed linear (or log-linear). In addition, shocks are assumed to follow an AR(1) process with white noise disturbances. The solution to this problem provides an optimal feedback rule for the monetary policy instrument which will be a linear, time-invariant function of all the variables and shocks that form part of the economy. 2. Implications for Monetary Policy

13 However, we are not currently in this type of framework: For many central banks, high inflation may be more costly than low inflation. The economy seems to behave differently in recessions than in booms (e.g., Hamilton (1989)). The shocks we are currently facing, as shown above, follow a very complex stochastic process, with regime shifts, time varying variances and extreme values. In addition, there is uncertainty about the duration of the “high inflation regimes” in commodity prices. In this context, the optimal response of monetary policy is likely to be non-linear and time-varying, and will tend to focus on risk management. 2. Implications for Monetary Policy

14 Following the risk management approach, the response to this environment should be preemptive, significant and transparent: Failure to act timely may lead to a contamination of the price-setting process; in particular, may affect the formation of inflation expectations. The response has to be strong, as central banks may prefer to insure against low probability, costly outcomes. The central bank has to clearly explain the rationale for its policy actions. But, as we will now see, how preemptive and strong the response should be, depends on the particular circumstances of each economy. 2. Implications for Monetary Policy

– 2007 Inflation Change and Inflation Persistence 2. Implications for Monetary Policy Source: WEO, IMF. Calculations by Banco de México. UK Por Can Jap Ire Spa Gre Fra Ita Ger HK USA Kor Tai Sin Mal Tha Phi Ind Inflation Persistence Change in Inflation from 2005 to 2007 Col Pan Sal Chi Par MexEcu Arg Gua Bra Jam CR Peru Nic Ven Uru Bol All Countries Only LA

16 2. Implications for Monetary Policy Source: WEO, IMF. Calculations by Banco de México – 2007 Inflation Change and Low Inflation Regime Ind Phil Thai HK Sin Gre Por Mal Ire Spa Ita Fra Can Ger Jap USA Tai UK Kor Duration of Low Inflation Periods (Years) Change in Inflation from 2005 to 2007 Ven Uru Peru Par Pan Bol Mex Col Chi Bra Bol Arg Ecu Sal Gua Jam Nic All Countries Only LA

– 2007 Inflation Change and CPI Food Weights 2. Implications for Monetary Policy Source: WEO, IMF. Calculations by Banco de México. Phil Ind Thai Mal UK Ger Ire USA Kor Sin HK Por Gre Spa Tai Jap Can Fra Ita CPI Food Weight Change in Inflation from 2005 to 2007 Mex Col Ecu Pan Chi Par Nic Gua Ven Uru CR Peru Jam Bra Bol Arg All Countries Only LA

18 Cumulative Change in Policy Target Rates and Inflation Persistence 2. Implications for Monetary Policy Source: WEO, IMF. Calculations by Banco de México. Fra Ire Por UK Jap Can USA Kor Ger Thai Mal HK Ind Gre Spa Ita Inflation Persistence Cumulative Change in Policy Rate (Basis Points) CR Peru Gua Bra Chi Uru Col Mex All Countries Only LA

19 Source: WEO, IMF. Calculations by Banco de México. Cumulative Change in Policy Target Rates and Low Inflation Regime Jap Tha Can Kor FraIre Por HK USA UK Gre Mal Ger Ita Spa Ind Duration of Low Inflation Periods (Years) Cumulative Change in Policy Rate (Basis Points) Gua Chi Per Mex ColUru Bra CR 2. Implications for Monetary Policy All Countries Only LA

20 2. Implications for Monetary Policy Source: WEO, IMF. Calculations by Banco de México. Cumulative Change in Policy Target Rates and CPI Food Weights Ita Ire US Ind Can Tha UK Mal HK Ger Jap Spa Fra Kor Gre Por CPI Food Weight Cumulative Change in Policy Rate (Basis Points) Bra Chi Uru Gua Per CR Col Mex All Countries Only LA

21 The optimal monetary policy response to “creeping inflation” depends on each country’s particular circumstances: The inflationary history of the country and, in particular, the extent to which a low inflation equilibrium has been sustained. The weight that food and energy goods have on the CPI. The degree of persistence that each economy’s inflation process exhibits to price shocks. The phase of the cycle the country is located in. The impact of the current environment on the country’s terms of trade. 2. Implications for Monetary Policy

22 The evidence suggests that the impact on inflation levels and inflation volatility of the worldwide shocks we have observed in the past years tends to be heterogeneous across countries. In particular: Inflation seems to have responded more to the price shocks in countries that still exhibit a higher degree of inflation persistence. Inflation volatility seems to be larger in those countries where the weight of foodstuffs in their consumer prices is higher, as well as in countries where the attainment of a low inflation equilibrium has been more recent. 2. Implications for Monetary Policy

23 Thus, the same external shocks may imply different monetary responses in different countries, given their own specific characteristics. In particular, countries that face higher risks of suffering large inflation increases and price volatility (due to their consumption baskets and their inflation history) may have found themselves in the need to respond more aggressively to the current price shocks than other countries. Indeed, the evidence does suggest that countries that are more vulnerable in these terms have acted accordingly, by restricting their monetary policy stance. 2. Implications for Monetary Policy

24 Given the evidence in the first part of this talk, a relevant question we should try to address with more research is: for how long will we be facing the current high commodity inflation regime? Up to this point, the discussion has centered on the policy responses to the current environment, given the policy frameworks that the central banks currently have. The answer to the question posed above could nonetheless have implications for the issue of whether central banks should rethink the definition of their monetary policy objectives. 2. Implications for Monetary Policy

Outline 1. Real Food and Oil Price Changes 2.Implications for Monetary Policy 3.Additional Considerations

26 Creeping inflation from the current shocks to energy and food prices may imply a restrictive bias in the monetary policy stance: This is especially true in countries where inflation is persistent, the low inflation equilibrium has not been sustained for a long time and where food and energy have a large weight in consumers’ spending. This, in turn, reflects the high costs that a breakdown of expectations-based nominal anchors that sustain the low- inflation equilibrium may have on these economies’ performance. Indeed, some countries may face a combination of the above mentioned features that may lead them to maintain a restrictive bias in their monetary policy, even when they may be currently facing the low phase of their business cycle. 3. Additional Considerations

27 The issues raised above focus on the implications of this high inflation regime for monetary policy. We have to ask to what extent we need to consider a more broad view of the policy response that we should undertake, given this environment. In particular we need to ask: Which other policy instruments are available to face the current environment? What is the optimal mix of policy responses to this environment, in order to minimize negative effects on welfare? 3. Additional Considerations

28 The policy mix clearly depends on the structure of each economy and on the shocks that each country has faced: Those who faced an improvement in terms of trade may use specific policies to redistribute the aggregate gains of the shocks to those groups that may have been hurt from price changes. Those that have faced a terms of trade deterioration also need to determine the optimal policy mix to minimize the welfare costs of this shock. 3. Additional Considerations

29 Fiscal policy May be helpful to redistribute losses (or gains, if terms of trade have improved), across different economic agents. Competition policy A non-competitive environment may exacerbate the impact of price shocks on domestic markets. Thus, antitrust agencies should avoid collusive practices in this environment of high price increases. 3. Additional Considerations

30 Real Crude Oil Price Changes (Proportion of Time Above Threshold) Source: IMF. Calculations by Banco de México. Appendix

31 Real Crude Oil Price Changes (Mean Above Threshold) Source: IMF. Calculations by Banco de México. Appendix