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Monetary Policy Frameworkand

“Insurance Against Deflation”

June,23 2008

Chuo UniversityKunio Okina

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Hara, Kimura and Okina(2008)

This paper is developed from the research conducted for Monetary Policy and Prices Working Group in the ESRI.Issue : how the CBs could offer “insurance against deflation” when CBs face uncertain environment.

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The purpose of this paper

The importance of “insurance against deflation” when inflation is close to zero is recently widely recognized. One of the rationales for such insurance is found in the simulation study by Ahearne, Gagnon, Haltmaier, and Kamin (2002) –hereafter called AGHK.

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Structure of this paper

Outline of AGHK--interpretation of the simulation

Introducing two alternative simulations using “JEM”

a DGE model comprising 219 eqs.

(Type 1) a departure from Taylor rule(Type 2) non-linear Taylor rule

Simulations results and summary

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Key Discussions of AGHK

Deflation can be very difficult to predict. Monetary policy should respond not only to baseline forecasts but also to downside risks.Had the BOJ lowered short-terminterest rates by a further 250 bp.between 1991 and early 1995, deflation could have been avoided.

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FOMC members view on AGHK

FOMC members often referred to AGHK and suggested the following:

“In Japan, deflation could probably have been avoided if the initial monetary response to the slump in real estate and stock market values had been more aggressive [Kohn(2006)].”

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How did AGHK lower short-terminterest rates in the simulations?

・AGHK introduces a permanentreduction of the intercept term of policy rules by 250 bp.The policy rules respect the zero bound on nominal interest rates: chose from the maximum of zero or the rate implied by a Taylor rule.

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Interpreting AGHK assumption

A reduction of constant term in Taylor rule can be regarded as:

an increase in target inflation rate (IT) or a decrease in natural rate of interest.

Are these policies reasonable?

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Implications of reducing the intercept term: increasing IT?

AGHK do not assume the increase in IT:“What if unanticipated favorable shocks had

lifted output gaps and…inflation well into positive territory? …a tightening of monetary policy by the BOJ in response would have caused …inflation eventually to decline back to its original baseline (p. 22).”

If a CB permanently maintains a higher inflation, economic welfare will deteriorate. It is unlikely for the CB to maintain such IT and announcement would not gain credibility.

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Downward Shift in Natural Rate of Interest

A CB is convinced of negative shock to the economy that would permanently decrease the natural rate, and announces that it will permanently lower the policy interest rate.The private sector agents place confidence in the announcement and form their expectations.

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Can CB be convinced of decrease in natural rate?

As AGHK repeatedly pointed out, long-term deflationary stagnation of the Japanese economy in the 1990s could not be anticipated in the early 1990s.It should not be easy for the CB to be convinced of permanent decline in the natural rate at an early stage.

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Japan’s economic outlook by FED: growth rate

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Japan’s economic outlook by FED: inflation rate

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Does The private sector believe in the CB’s announcement?

For the lowering of interest rates to have an effect of monetary easing, only the natural rate in the policy rule has to decline, while that in IS curve needs to remain. To satisfy such assumptions, the private sector has to have confidence in the CB’s perception on the natural rate, while keeping its own perception permanently.

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Can Regime Shift of AGHK considered as a policy option?

AGHK’s assumption is simple andlooks easy to adapt In reality, however, it cannot be a policy option for future CBs

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Simulations Using JEMThe JEM model: Japanese Economic Model (developed by BOJ)-- a large-scale dynamic general equilibrium model-- comprising 219 equationsEssence is summarized in 2 eqs.: The Phillips Curve and the IS curve-- both are hybrid expectations (forward and backward-looking) equations

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Purpose of our Simulations

Look for alternative policy frameworks that can be :

useful to avoid deflation feasible under strong uncertaintyfree from significant side effects.

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Simulations Using JEM

We examine two approaches. (1) CB commits to depart from the Taylor rule for a certain period of time.

But it also makes a commitment to return to the standard Taylor rule after that.

(2) CB changes the Taylor rule to respond non-linearly and aggressively to the increased risk of deflation.

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Departure from the Taylor Rule for a Certain Period

Simulation on two deflationary periods in Japan in the recent period:

Early 90s (After the bubble period)Mid 80s (During the High-Yen Recession)

Considerdifferent starting pointsdifferent lengths of departure from Taylor Rule

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Why we add mid 80s?

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Time-limited departure from the Taylor rule is not fail-safe

If the departure be sufficiently long, deflation can be avoided if economy actually suffers a deflationary shock subsequently, as the results of AGHK.However, if there is a subsequent inflationary shock after monetary loosening, the departure needs to be short; otherwise, inflation and instability cannot be avoided.

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Adoption of Non-Linear Reaction Function

Adopt non-linear Taylor rulemonetary policy reacts more expansive when the economy is deflationary

Introduce two rules:Rule 1: Change the constant term depending on gapRule 2: Increase responsiveness when a deflation gap emerges

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Adoption of Non-Linear Reaction Function (2)

Simulations are conducted on 90ｓWe do not try simulations in mid 80s because if there is a subsequent inflationary shock, RF become simple Taylor rule.

For the target inflation rate, we assume π * = 1% for both Rule 1 and 2, based on the BoJ’s statement.

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Rule 1： Change the constant term depending on gap.

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Rule 1 (continue)

ψNL the time-varying parameter （0 <ψNL <1) -- depends on a prevailing economic situation xt

--weighted sum of output gap and inflation gap

1) ψNL gets closer to zero when a deflation gap ( xt < 0 ) becomes larger, 2) ψNL ≈ 1 when an inflation gap ( 0 > xt ) exists.

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Results of Simulations Using Non-Linear RF (1)

Under both rules, deeper interest rate cuts start after the second half of 1993. Monetary policy does not alter the long-term stagnation of the Japanese economy substantially.However, deflation can be narrowly avoided, at least until 2001.

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Results of Simulations Using Non-Linear RF(2)

Average interest rates are not substantially lower than the historic figures.Moreover, IT is set at 1%. Thus our results do not rely on a higher IT. Under these weak assumptions, a reasonable policy effect can be achieved in terms of mitigation of the risk of deflation.

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Summary of our results(1):Comparison of 2 approaches

To make a commitment of time-limited downward shift of the Taylor rule is not considered to be a fail-safe.A reasonable policy effect is observed with non-linear policy response function, since deflation is avoided during the simulation periods.

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Summary of our results(2 ):Non-Linear RF

The results of Non-Linear RF are caused by a forward-looking expectation on aggressive monetary policy. Thus, adverse deflationary impact due to economic agent awareness of the zero bound on interest rate can be mitigated.

Though the policy cannot be expected to alter long-term stagnation such as in the 1990s.

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Summary of our results(3)：what is not required

What is not necessary:To cut interest rates significantly in the early stages of disinflation and commit to maintain low interest rates under strong uncertainty. To set a unrealistic high target inflation rate that cannot possibly create confidence.

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Summary of our results(4):what is required

To announce the course of action that the policymaker will take at the stage where the risk of deflation becomes apparent to a certain degree. Moreover, the policymaker will return to normal rule when the risk of deflation becomes remote.