1. 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

2. 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

3. 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

4. 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

5. Recent Experience: U.S. 2000 will be 18th year of the “Long Boom”
First and second longest peacetime expansions in U.S. history
1991- ,
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 ( ) had 5 recessions
Before 1982 in recession 35 percent of the time
Since 1982 in recession less than 4 percent of the time

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

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

8. 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?

9. 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

10. Smoothed inflation rate (4 quarter average) 812
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

11. Many other Experiences Inflation/Output Stability Before and After Inflation Targeting (percent) Source: Cecchetti and Ehrmann(1999)
Period
inf
growth
Before:
15.0
7.5
After:
3.3
6.9
Difference
11.7
0.6
Australia
Canada
Chile
Finland
Israel
New Zealand
Spain
Sweden
U.K.

12. 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

13. 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

14. 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 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

15. - 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:

16. - 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:

17. 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:

18. - 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:

19. 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

20. 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

22. 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

23. 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

24. 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

25. Put exchange rate in policy rule
One approach: Place exchange rate into interest rate rule
it = gt + gyyt + ge0et + ge1et 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).

26. Simulation results with exchange rate

27. 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

28. 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))

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

30. 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...

31. 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”