On Inflation Targeting: Celebrating 1 Year of IT in Brazil Klaus Schmidt-Hebbel Central Bank of...
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On Inflation Targeting: Celebrating 1 Year of IT in Brazil Klaus Schmidt-Hebbel Central Bank of Chile Conference on “One Year of Inflation Targeting in Brazil” Rio de Janeiro, July 10-11, 2000
On Inflation Targeting: Celebrating 1 Year of IT in Brazil Klaus Schmidt-Hebbel Central Bank of Chile Conference on “One Year of Inflation Targeting in
On Inflation Targeting: Celebrating 1 Year of IT in Brazil
Klaus Schmidt-Hebbel Central Bank of Chile Conference on One Year
of Inflation Targeting in Brazil Rio de Janeiro, July 10-11,
2000
Slide 2
Outline (1) WHO DOES IT? (2) IT IN TRANSITION TO LOW INFLATION
(3) HOW SUCCESSFUL HAS BEEN IT ? (4) REMAINING OPEN ISSUES ABOUT IT
(5) CONCLUDING REMARKS (6) REFERENCES
Slide 3
(1) WHO DOES IT?
Slide 4
Slide 5
Slide 6
IT Countries and Year of Adoption Source: Schaechter, Stone and
Zelmer (2000)
Slide 7
Some countries with partial IT regime: Colombia Mexico Peru
Some countries currently considering adoption of IT: Japan Thailand
Turkey
Slide 8
(2) IT IN TRANSITION TO LOW INFLATION
Slide 9
Cumulative Jan. 1991- May 2000 Relative (Absolute) Deviation
from Targets: 1.9%(3.9%) Inflation and Inflation Targets
(Smoothened) in Chile
Slide 10
Slide 11
Slide 12
Brazil adopted IT under the most unfavorable initial conditions
observed in any IT experience in the world - with outstanding
results regarding inflation, growth, and external position Adopting
IT with most bells and whistles in place has paid off handsomely
Brazil confirms the paramount importance of correcting fiscal
fundamentals and improving health of the banking system for IT to
succeed - future persistence in both dimensions is needed Brazil
also shows that flexible exchange rates in open economies with low
inflation exhibit small devaluation-to- inflation passthrough
(confirming Goldfajn and Werlang 2000) However Brazils experience
also reflects the special tensions and issues confronted by ITers
in transition to low inflation Some Lessons from 1 Year of IT in
Brazil
Slide 13
IT in transition to low inflation is very different from IT in
steady-state inflation: Policy credibility is initially low it is
built up only by showing a good track record Short (annual) target
horizon makes it hard to achieve targets Hence there is a bias
toward overreacting to adverse shocks and to temporary shocks
inflation hawkishness and policy asymmetry Ironically, the latter
is needed to (over-) achieve targets in order to establish
credibility Issues of IT in Transition to Low Inflation (I)
Slide 14
Speed of adjustment (convergence period) to stationary
inflation is dependent on credibility, inflation indexation
mechanisms, inertia. However, the decade-long Chilean and Israeli
experiences of transition to low stationary inflation (and possibly
the shorter Brazilian experience) suggest that the convergence
period was excessively long, as ex post sacrifice ratios were
likely lower than anticipated ex ante. Issues of IT in Transition
to Low Inflation (II)
Slide 15
(3) HOW SUCCESFUL HAS BEEN IT?
Slide 16
Evidence from OECD Economies (Bernanke, Laubach, Mishkin, and
Posen): 1. Does IT make disinflation less costly? No: sacrifice
ratios and Phillips curves are not altered by IT 2. Does IT reduce
inflation expectations? Not quickly, only gradually over time
(consistent with 1) 3. Does IT reduce inflation? Yes: IT delivers
lower long-run inflation than what would have been achieved in its
absence. But IT is not a necessary condition for low long-term
inflation.
Slide 17
Evidence from OECD and emerging economies (Cecchetti and
Ehrmann) Model: determines central bankers aversion to inflation
variability from the sacrifice ratio (calculated from VAR impulse
responses) and inflation and output variability Full sample results
for the inflation aversion coefficient ( ): Average for the sample
of 9 ITers (including Chile and Israel) is 0.71-0.76, very close
to: Average of control group of 14 non-ITers (including 2 emerging)
is 0.73-0.74 But: the s of ITers increase substantially either
before or after starting IT (see figure)
Slide 18
Slide 19
(4) REMAINING OPEN ISSUES ABOUT IT
Slide 20
Design Issues Operational (or instrument) independence alone?
Yes, but... Which level of long-run inflation objective? Squeezed
between Friedman, Keynes, and Harrod-Balassa-Samuelson.... Point or
Range Targets? No point will be met but any range is still too
narrow... Targeting headline or core inflation? Credibility vs.
relevance... Strict or relaxed accountability of Central Bank
performance? Transparency, rules and discretion... Is IT with all
bells and whistles a necessary or just a desirable prerequisite
when starting IT? A lesson from Brazil...
Slide 21
Research Issues Observational equivalence between an explicit
IT framework (say the UK) and other non-explicit monetary
frameworks (say the U.S. or the Bundesbank before the Euro) or
mixed regimes (Euroland) Asymmetries and lags in inflationary
effects of both shocks and monetary policy actions are not known
with precision Lack of agreement of optimal policy response to
various types of shocks (nominal-real.financial, supply-demand,
permanent-transitory - their difference not known ex ante) Lack of
understanding monetary transmission mechanisms and their empirical
relevance is widespread
Slide 22
Monetary Transmission and Policy Rule in Open Economies Output
Gap, Employment Absorption- Income Gap (CA) Real Exchange Rate
Monetary Policy Rule Projection of Core-Target Inflation Gap Core
Inflation T Inflation NT Inflation Monetary Policy Rate Inflation
Expectations Market Rates /Term Structure Monetary/Credit
Aggregates Asset Prices (Wealth) Nominal Exchange Rate
Slide 23
Model Development and Use A necessary, continuous, and costly
process requires significant research capabilities Chiles case:
current development of toolkit comprised by various (small) models
used in explaining, forecasting, and simulating. They comprise:
Leading indicators of prices and activity Small semi-structural VAR
models (4 to 7 variables) Flow-stock consistency model Small
backward-looking macro model for key relations and variables
(inflation, Phillips curve, activity, absorption (or current
account), potential output, imperfect interest parity, yield curve)
Micro-founded forward-looking rational expectations model for key
relations and variables Model development and use has been a
learning process in emerging economies, at variable speed depending
on needs and capabilities.
Slide 24
Conduct of Monetary Policy (I) (problems also apply to other
monetary frameworks) Large gaps in above mentioned theoretical and
empirical knowledge monetary policy is conducted under high level
of model and parameter uncertainty Hence: is it feasible to
forecast IT with a simple model? Yes, but development of a menu of
increasingly complex models raises understanding and the level of
policy discussion
Slide 25
Conduct of Monetary Policy (II) Which weight should be attached
to current variables (say inflation) as compared to predicted
future variables? Answer often leads to symmetrical policy inertia
Which is the optimal speed and intensity of policy reaction to a
given shock? Depends on various factors, including: uncertainty
about shock feature, weight of arguments in objective function,
degree of central bank aversion to frequent policy
adjustments.
Slide 26
Conduct of Monetary Policy (III) Which arguments should be
included in the monetary policy rule? 1. Inflation deviations only
(inflation nutter) 2. Inflation deviations plus output deviations
(simple Taylor rule; possibly a majority of economists), but with a
large weight attached to the former (inflation hawks) 3. Inflation
deviations plus output deviations plus exchange rate deviations
(ECB?) or current-account deviations (some emerging economies CBs)
4. Inflation deviations plus output deviations plus asset price
deviations: No: Bernanke and Woodford (1999) Yes: Cecchetti et al.
(2000)
Slide 27
(5) CONCLUDING REMARKS 1. IT - combined with exchange-rate
floating - seems to be the main alternative to dollarization or
monetary union 2. IT in transition is very different and,
typically, more difficult than IT in steady-state low inflation 3.
Brazils IT experience is the boldest experience of adopting IT and,
most likely, the worlds most successful one when controlling for
initial conditions 4. Yet a large number of issues on IT design and
performance, and on the conduct of monetary policy under IT, have
to be addressed to better understanding IT in the world, including:
the fine print on IT design and operation, opening up the the black
box of monetary transmission, and deriving and defining more
transparently an optimal policy rule.