1. How Does Monetary Policy Change? Evidence on Inflation Targeting Countries Jaromír Baxa, Charles University, Prague Roman Horváth, Czech National Bank Bořek Vašíček, University of Barcelona The 7th Norges Bank Monetary Policy Conference, 24 June 2010 The views expressed here do not necessarily represent those of the CNB.

2. 2 Road Map Motivation Related Literature Data and Empirical Methodology Empirical Results Concluding Remarks

3. 3 Motivation How and when does monetary policy change? Does inflation targeting represent a major change in monetary policy? When do central bankers respond more aggressively on inflation? To what degree the policy is smoothed? How persistent is inflation process? How important is financial stress for interest rate setting?

4. 4 Related Literature – Monetary policy rules and inflation targeting Most studies available for the Bank of England (1992): Clarida et al.(1998, 2000), Adam et al. (2005), Davradakis and Taylor (2006), Assenmacher-Wesche (2006), Trecroci and Vassalli (2009) Reserve Bank of New Zealand (1990): Huang et al. (2001),Karedekikli and Lees (2007), Ftiti (2008) Reserve Bank of Australia (1993): Bouwer and Gilbert (2005), Leu and Sheen (2006) Bank of Canada (1991): Demers and Rodríguez (2002), Shih and Giles (2009) Sveriges Riksbank (1993): Jansson and Vredin (2003), Kuttner (2004), Berg et al. (2004)

5. 5 Related Literature – Time variance in monetary policy rules (1) Sub-sample analysis with forward-looking policy rules (Clarida et al., 1998, 2000) Endogenous regressors addressed by GMM Strong assumption that monetary policy is subject to structural breaks when the FED chairman changes Structural stability within sub-sample assumed

6. 6 Related Literature – Time variance in monetary policy rules (2) The Markov-switching VARs with time variance in coefficients and residual variances (Assenmacher-Wesche, 2006, Sims and Zha, 2006) Time variance in coefficients and residual variances to deal with changing monetary policy and economic stability Monetary policy forced to exhibit sudden switches from one policy regime to another one Forward-looking element in monetary policy not explicitly addressed

7. 7 Related Literature – Time variance in monetary policy rules (3) The Kalman filter to estimate time-varying coefficient model (Boivin, 2006,Trecrocci and Vasalli, 2010, Gorodichenko and Coibion, 2010) Time variance in coefficients and residual variances to deal with changing monetary policy and economic stability Endogenous regressors typically not addressed (Kim and Nelson, 2006) Endogeneity even in forward-looking rules with real-time forecasts, if forecasts not derived under assumption of constant nominal interest rates within the forecasting horizon

8. 8 Our econometric framework Time-varying coefficient model with endogenous regressors The policy may change gradually as well as abruptly Heckman-type two stage procedure that corrects endogeneity in time-varying model (Kim, 2006) Small sample issues: Moment-based estimator that has slightly better statistical properties in small samples than traditional Kalman filtering (Schlicht and Ludsteck, 2006)

9. 9 Empirical methodology Monetary policy rule Time-varying coefficients follow random walk Endogenous regressors and instruments ( Z ),,

10. 10 Empirical methodology (cont.) Estimates of the coefficients in the monetary policy rule are obtained in two steps 1.Endogenous regressors regressed on the instruments and standardized residuals and saved 2.Standardized residuals included as endogeneity bias correction terms in monetary policy rule

11. 11 Varying Coefficients “Varying coefficients” method (Schlicht and Ludsteck, 2006) for estimation Minimal assumptions on the variance of error terms Generalization of OLS, minimizes the weighted sum Weights inverse variance ratios of the regression residuals and the shocks in time-varying coefficients balancing the fit of the model and the parameter stability

12. 12 Data Quarterly data UK 1975:1Q -2007:4Q, Australia 1972:4Q - 2007:4Q, Canada 1975:1Q - 2007:4Q, New Zealand 1985:1Q - 2008:2Q, Sweden 1982:2Q - 2007:3Q The dependent variable is the short-term interest rate closely linked to monetary policy The inflation rate is measured as year-on-year change of CPI (RPIX for the UK and CPIX for NZ) The output gap is from OECD: production function method based on NAWRU (HP filter for NZ) The nominal effective exchange rate (USD/CAD for CAN) used in its deviation from HP trend Foreign interest rate – German rate for EU countries, US for the rest

13. 13 Results - Sweden Policy neutral rate falling from some 5% in 1980s to 3% in 2000s Response to inflation strong, but somewhat less aggressive under IT (anchored expectations) No response to output gap IR smoothing somewhat higher than in other countries 95% confidence interval

14. 14 Results – Monetary Policy Aggressiveness and Inflation Targeting Monetary policy less aggressive after IT adoption, if previous inflation record favorable Anchored inflation expectations under IT do not necessitate aggressive policy

15. 15 Results - Monetary Policy Aggressiveness and Inflation Rate The response on inflation particularly strong during the periods, when central bankers want to break the record of high inflation

16. 16 Results – Interest Rate Smoothing Time-varying estimates of interest rate smoothing are well below the time-invariant one of Clarida et al. Is omission of time-varying nature of policy another reason for the overestimation of smoothing coefficient?

17. 17 Results - Inflation Targeting and Inflation Persistence Inflation less persistent after IT adoption Persistence measured as the coefficient on lagged inflation in backward-looking Phillips curve with time-varying coefficients

18. 18 Follow-up paper Time-Varying Monetary Policy Rules and Financial Stress To what extent is financial stress important in interest rate setting? To what extent financial stress mattered for conventional monetary policies during 2008-2009 crisis?

19. 19 Time-varying monetary policy rule estimation for main IT countries and US IMF’s Financial stress indicator (and its subcomponents) added as additional explanatory variable Do central banks respond to financial stress? Which periods and type of stress are for central banks the most worrying?

20. 20 Results - The Effect of Financial Stress on Interest Rate Setting Central bank loosen policy in the face of high financial stress Financial stress explain 10-50% of interest rate variations during 2008-2009 crisis (50% for the U.K)

21. 21 The Effect of Financial Stress Components on Interest Rate Setting: Bank, Exchange Rate and Stock Market Stress Exchange rate stress of more concern in more open economies Bank stress and stock market stress dominant

22. 22 Concluding Remarks The evolution of monetary policy in main IT central banks over the last three decades examined Policy changes gradually rather than abruptly The response on inflation more aggressive during the periods when central bankers want to break the record of high inflation The response on inflation less aggressive after IT adoption Central banks loosen monetary policy in the face of high financial stress

23. Thank you for your attention Děkuji Vám za pozornost (in Czech) www.cnb.cz Contacts: Roman Horváth Czech National Bank roman.horvath@cnb.cz http://works.bepress.com/roman_horvath/