L11-Inflation and Monetary Policy

Lecture 11

Inflation and monetary policy

Hubert Kempf

Economic policies

Master in economics

Inflation and monetary policy

1 – Inflation dynamics – recent trends and monetary policy strategy issues

2 – Inflation and monetary policy strategies: an overview

1 – Inflation dynamics

1.1 – Global trends

1.2 – Price developments in the euro area 1.3 – Monetary policy / strategy implications

1.1 – Recent trends: global disinflation

Global inflation (% y-o-y)

0

5

10

15

20

25

30

35

40

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

Advanced economies World (All WEO countries)

Tentative explanations

1 – Good Luck?

• absence of adverse supply shocks in the 1990s

• positive supply shock: new economy

• Positive supply change: globalisation

2 – Good Practices?

• inventories

• price and wage setting in a context of well anchored inflation expectations

• increased competition

3 – Good Policies?

• stability-oriented macroeconomic policies

1.2 – Price developments in the euro area

-2

0

2

4

6

8

10

12

14

16

Source: ECB - M. Ehrmann and F. Smets (2005).

Note: The chart shows quarter-on-quarter (red) and year-on-year (blue) inflation, and its average value over three sub-periods that have been identified by breakpoint tests.

HICP and core inflation

Figure 1: inflation and underlying inflation in the euro area(1999M1-2005M9)

0

0,5

1

1,5

2

2,5

3

3,5

perc

enta

ges

Inflation

Underlyinginflation

Inflation persistence in the Euro Area – Macro evidence

tutt uaLa 10 )(

....)( 2321 LLL

%9,1)1(1

* 0

a

40.0

* : Inflation de LT

Dependent Variable: π

Method: Least Squares

Date: 02/10/05 Time: 10:38

Sample (adjusted): 1995M01 2004M12

Included observations: 120 after adjustments

Variable Coefficient Std. Error t-Statistic Prob.

π(-12) 0.659205 0.090646 7.272268 0.0000

π(-24) -0.251187 0.073918 -3.398205 0.0009

C 1.176806 0.152120 7.736041 0.0000

R-squared 0.323390 Mean dependent var 1.977511

Adjusted R-squared 0.311824 S.D. dependent var 0.527215

S.E. of regression 0.437358 Akaike info criterion 1.208554

Sum squared resid 22.38002 Schwarz criterion 1.278241

Log likelihood -69.51323 F-statistic 27.96047

Durbin-Watson stat 0.343231 Prob(F-statistic) 0.000000

Price stickiness: micro data evidence

Eurosystem Inflation Persistence Network

- Analysis of CPI micro data

- Analysis of producer prices

- Survey evidence (à la Blinder, 1998)

Based on “Price Setting in the euro area: Some stylised facts from Individual Consumer Price Data” by Dhyne, Álvarez, Le Bihan, Veronese, Dias, Hoffmann, Jonker, Lünnemann, Rumler and Vilmunen (2005)

Raw data: (millions of) individual price records

from data underlying the CPI

Common sample: 50 product categories

representative of CPI

10 euro area countries : AT, BE, DE, ES, FR, FI,

IT, LU, NE, PT

Countries not covered : GR, IR (3% of area GDP)

Period covered : January 1996 - December 2001

Fact 1: prices change infrequently (on average once every year)

Average frequency of price changes for the euro area : 15.1 % per month. Average duration of a price spell (based on indirect estimators): 4 to 5 quarters. Compared to the US: price adjustment in the euro area less frequent(respective US figures are around 25% and 2 quarters)

Stylized Facts

0

5

10

15

20

25

30

0 5 10 15 20 25 30

euro area

Uni

ted

Sta

tes

(months)

(mon

ths)

Product level price duration - Euro area vs US(product averages)

Fact 2: When they occur, price changes tend to be quite large

Absolute magnitude around 8-10% in the retail sector and about 5% in the producer sector The magnitude of price reductions (10%) is roughly similar to that of price increases (8%).

Therefore, price of goods not changed around average or past inflation

Fact 3: No strong evidence of downward price rigidity in the euro area.

Price decreases are not uncommon, except in services

In services, small price increases are common and decreases very rare.

On average, 40% of price changes are price reductions.

0

0.15

0.3

0.45

0.6

0 0.15 0.3 0.45 0.6

Frequency of price increases

Fre

qu

en

cy

of

pri

ce

de

cre

as

es

0

0.125

0.25

0.375

0.5

0 0.125 0.25 0.375 0.5

Size of price increases

Siz

e of

pri

ce d

ecre

ases

Sectoral ranking. Price changes are :

- very frequent for energy (oil products-F=78%) and unprocessed food (28%), - relatively infrequent for non-en. industrial goods (9%)

- more so for services (6%).

Fact 4: Cross-product heterogeneity is substantial

Frequency of price increases and price decreasesEuro area figures in p.c. (using HICP weights)

0.580.800.570.540.540.54Share of price increases

0.060.010.030.360.060.13Frequency of price decreases

0.080.040.040.420.070.15Frequency of price increases

0.150.060.090.780.140.28Frequency of price changes

TotalServicesNon-energy industrial

goods

EnergyProcessed food

Unprocessed food

Distribution of the frequency of price changes

0.00

0.02

0.04

0.06

0.08

0.10

0.12

0.14

0.16

0.18

0.20

[0; 0

.02)

[0.1

; 0.1

2)

[0.2

; 0.2

2)

[0.3

; 0.3

2)

[0.4

; 0.4

2)

[0.5

; 0.5

2)

[0.6

; 0.6

2)

[0.7

; 0.7

2)

[0.8

; 0.8

2)

[0.9

; 0.9

2)

Frequency of price changes (in p.c.)

Den

sity

(in

p.c.

)

Fact 5: Cross-country heterogeneity is relevant but not as marked

Frequency ranges from 10% (Italy) to 23%

(Luxembourg)

Partly related to :

- the consumption structure

- the statistical treatment of sales.

Fact 6: Weak synchronisation of price changes across price-setters at the product level

Synchronization Ratio

min median max

at 0.12 0.21 0.85be 0.09 0.18 0.86de 0.06 0.13 0.44es 0.06 0.15 0.45fi 0.16 0.36 1.00fr 0.09 0.19 0.78it 0.08 0.24 0.60lu 0.19 0.48 1.00nl 0.09 0.27 1.00pt 0.11 0.17 0.90euro 0.08 0.18 0.62

Note: Fisher and Konieczny. (2000) index

FK=0 for perfect staggering and

FK=1 for perfect synchronisation

Other statistical evidence

From country studies:● Time-dependence:

• Seasonal patterns : changes more frequent in January and September

• Durations of 12, 24 and 36 months

● State-dependence. Probability of price changes responds to

• Indirect tax rate changes, euro cash changeover• level of aggregate inflation, sectoral or product level

inflation• variability of sectoral or product level inflation

Frequency of price change over time - French CPI data

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

total (incl. replacements) increases decreases

Euro cash changeoverVAT decreaseVAT increase

Source: Baudry, Le Bihan, Sevestre, Tarrieu (2004)

1.3 - Monetary policy implications

To recap :

1) Euro area has been hit by a series of cost-push shocks over the past six years

2) The degree of inflation persistence limited in the

euro area and similar to that of the US…

3) But the degree of price stickiness is

considerable and higher than in the States

Policy implications (1)

1) A smaller degree of inflation persistence implies a smaller response of policy rate to cost-push shocks

2) A higher degree of price stickiness implies a

greater effectiveness of monetary policy and a less

activist monetary policy

3) But it also implies a slower response to other

shocks (as productivity shocks) which calls for

more a aggressive monetary policy response


Caveats :

1) Uncertainty about the degree of inflation

persistence and price stickiness

2) When inflation expectations are a key

determinant of the degree of inflation persistence

3) Heterogeneity in price stickiness (service sector)


Downward price rigidity: it is often argued that downward price rigidity implies a higher inflation objective to facilitate relative price adjustments;

the absence of downward price rigidity may call for a more ambitious inflation objective

2 – Inflation and monetary policy strategies

2.1 – An overview of current strategies

2.2 – Pro and cons 2.3 – A focus on Inflation targeting

2.1- An overview of Monetary policy strategies

Rule-based Discretion

CurrencyBoard

ExchangeRate peg

Crawling peg

Inflationtargeting

Multiplemandate

1 - Monetary policy framework

2 - communication

Simple Complex

Monetarytargeting

Exchange Rate Regime

Monetary Inflation IMF-aggregate targeting supported

target framework mon. Prog.

Another

Euro area

(12)3

currency

Austria

as legal Belgium

tender (9) Finland

FranceGermany

Greece

Ireland

Italy

LuxembourgNetherlands

WAEMU CAEMC PortugalEcuador Antigua and Benin Cameroon* Spain

El Salvador4 Barbuda Burkina Faso* Central

Kiribati Dominica* Côte d'Ivoire* African

Marshall Islands

Grenada Guinea-Bissau Rep.

Micronesia, St. Kitts and Mali* Chad

Fed. Nevis Niger Congo,

States of St. Lucia Senegal* Rep. of

Palau St. Vincent Togo Equatorial

Panama and the Guinea

San Marino Grenadines Gabon*

Timor-Leste

Brunei Darussalam

BulgariaChina-Hong Kong SAR

Djibouti

Estonia9

Lithuania9

Currency board arrangements (7)

Bosnia and Herzegovina

CFA franc zone (14)

Monetary Policy Framework

Exchange rate anchor OtherExchange arrangements with no separate legal tender (41)

ECCU (6)2



target framework mon. Prog.China,

P.R. of†6


Exchange rate anchor Other

Bolivariana de

Zimbabwe6

United Arab EmiratesVenezuela, Rep.

Turkmenistan6

Ukraine*6

Swaziland

Syrian Arab Rep.5

Seychelles6

Suriname5,6

QatarSaudi Arabia

Netherlands Antilles

Oman

Namibia

Nepal*

Malaysia

Maldives

Lesotho*

Macedonia, FYR*6

Kuwait

Lebanon6

Iraq 6

Jordan*6

Eritrea

Guinea6

Morocco

China, P.R. of†6 Samoa

Comoros7 Vanuatu

composite (8)

Aruba Botswana5

Bahamas, The5 Fiji

Bahrain, Kingdom of LatviaBarbados

Other conventional fixed peg arrangements (42)

Against a single currency (34)

Against a

Libyan Arab

Belize Jamahiriya

Bhutan Malta

Cape Verde*



target framework mon. Prog.

Crawlingpegs (6)

Bangladesh* Czech Rep. Argentina* Afghanistan,

Cambodia5 Peru*6 Azerbaijan* I.S. of

Egypt5 Thailand Croatia Algeria3

Ghana*6 Ethiopia* Angola 3

Guyana* Georgia* Burundi*3

Indonesia Haiti3,6 Gambia,

The* 3,6

Iran, I.R. of Kenya* India3

Jamaica6 Kyrgyz Rep.* Kazakhstan3

Mauritius Lao PDR*5 Mauritania*

Moldova Mongolia* Myanmar3,5,6

Sudan Mozambique6 Nigeria6

Zambia* Pakistan* Paraguay*3

Rwanda* Russian

Federation3

Serbia and São Tomé

Montenegro*11 and Príncipe

Tajikistan* Singapore3

Vietnam Slovak Rep.3

Trinidad and

Tobago

Uzbekistan3,5



Romania6 Managed floating with no pre-determined path for the exchange rate (48)

Exchange rates within

Belarus

Costa Rica

Honduras*6

Nicaragua*

Solomon Islands6

Tunisia

Bolivia* Tunisia Honduras*6

Hungary†

Denmark9 Cyprus

Slovenia9 Hungary†

Tonga

Pegged exchange rates within horizontal

bands (5) 8

Within a cooperative arrangement (2)

Other band arrangements (3)



target framework mon. Prog.Malawi* Australia Albania* Dominican

Sierra Leone*6 Brazil* Armenia* Rep.*3

Sri Lanka* Canada Congo, Dem. Japan 3

Uruguay* Chile5 Rep. of* Liberia3,6

Yemen, Colombia* Madagascar* Papua New Rep. of Guatemala Tanzania* Guinea3

Iceland

Israel†6

Uganda* Somalia5,12

Korea Switzerland3

Mexico United States3

New ZealandNorwayPhilippinesPolandSouth Africa

Sweden

Turkey*

United Kingdom

Independently floating (36)



2.2- Pro and cons of alternative policy regimes

1 - Exchange-rate pegging: from currency board to crawling peg:

Pros…

• provides an nominal anchor

• prevents time-inconsistency

• corrects low credibility

• monetary policy bound by a rule

• simple and clear to communicate

• can lower inflation quickly

…and cons:

• loss of an independent monetary policy (idiosyncratic shocks)

• little scope for discretion

• transmission of shocks from the anchor country

• leaves the country open to speculative attacks

• eliminates lender-of-last-resort function

Objective: peg the currency to that of a large, low inflation country

2 – Monetary targeting

Pros…

• independent monetary policy

• nominal anchor

• high frequency publication of monetary aggregates

• monetary policy bound by a rule

• fairly easy to communicate

…and cons:

2 big ifs:

• relies on the existence of a strong relationship between the goal variable and the targeted aggrate

• the targeted aggregate must be well-controlled by the central bank

Objective: money growth as an nominal anchor

3 – Inflation targeting

Pros…

• transparent monetary policy

• clear commitment to price stability

• accountability

• helps focus the public attention to price stability

…and cons:

• inflation not easily controlled

by central banks

• inflation outcomes revealed with substantial lags

• sole focus on inflation that may lead to larger output fluctuations

Objective: public announcement of a medium-term numerical target for inflation with an institutional commitment by the CB to achieve this target

4 – Multiple mandate

Pros…

• track records: it worked well

• discretion

…and cons:

• Lack transparency

• may create economic and financial uncertainty

• time-inconsistency

• absence of nominal anchor make higher inflation likely

• strong dependence on individuals: The Magic Greenspan

Objective: pre-emptive monetary policy without an explicit nominal anchor

Conclusion

Fighting inflation: more than manipulating money supply!

Why monetary regimes and rules are important?

Because of the role played by expectations!

The dynamics of pricing behaviour and therefore of inflation

Necessary to play on expectations!

L11-Inflation and Monetary Policy

Documents

Transcript of L11-Inflation and Monetary Policy