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

-10

-5

0

5

10

15

20

60 65 70 75 80 85 90 95

percent

Real GDP growth rate (Quarterly)

-6

-4

-2

0

2

4

60 65 70 75 80 85 90 95

percent

GDP gap with HP trend for potential GDP

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

0

2

4

6

8

10

12

60 65 70 75 80 85 90

Inflation rate

Smoothed inflation rate

(4 quarter average)

1968.1: Funds

rate was 4.8%

1989.2: Funds

rate was 9.7%

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

AustraliaCanadaChileFinlandIsraelNew ZealandSpain SwedenU.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

PriceWaterhouseCoopersIf 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

      

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

      

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

       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

Policy Rule

Constant Real Interest Rate

Interest rate

Inflation rateTarget

Important Threshold Result: Slope Should be Greater 1

Robustness of Simple Rules

Monetary policy rules of the form

it = gt + gyyt + it-1

where i is the nominal interest rate,

is the inflation rate

y is the deviation of real GDP from potential GDP.

g gy

Rule I 1.5 0.5 0.0 Rule II 1.5 1.0 0.0 Rule III 3.0 0.8 1.0 Rule IV 1.2 1.0 1.0 Rule V 1.2 .06 1.3

Inflation Forecast Based Rules• it = g(Ett+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 Ett+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 = gt + gyyt + ge0et + ge1et-1 + it-1

 whereit 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).

Effect on inflation and output variability from adding exchange rate terms to Taylor rule. (No exchange rate term in loss function) Set g = 1.5, gy = 0.5, = 0, and

ge0 ge1

_________ Ball -.37 .17 slight improvement Svensson -.45 .45 can’t rank Taylor -.25 .15 can’t rank

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))

Policy Rule

Constant Real Interest Rate

Interest rate

Inflation rate0Target

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”