May 8th, 2008 Creeping Inflation: How much of a concern? What should the response be? XXVII Meeting...

May 8th, 2008

Creeping Inflation: How much of a concern? What should the

response be?

XXVII Meeting of the Latin American Network of Central Banks and Finance Ministries

Alberto TorresBanco de México

Outline

1. Real Food and Oil Price Changes

2. Implications for Monetary Policy

3. Additional Considerations

3

Commodity Price Indexes(Index Jan 2003 = 100)

Source: IMF.


80

130

180

230

280

330

380

Jan-

03

Jul-0

3

Jan-

04

Jul-0

4

Jan-

05

Jul-0

5

Jan-

06

Jul-0

6

Jan-

07

Jul-0

7

Jan-

08

90

140

190

240

290

340

390

440Non FuelFoodCrude OilMetals (right axis)

4

Real Food Price Changes(Annual % Change of Real Price)

Source: IMF. Calculations by Banco de México.


-40

-30

-20

-10

0

10

20

30

40

50

Jan-

81

Jan-

83

Jan-

85

Jan-

87

Jan-

89

Jan-

91

Jan-

93

Jan-

95

Jan-

97

Jan-

99

Jan-

01

Jan-

03

Jan-

05

Jan-

07

Food Mean per regime

5


40

20

0

-20

Distribution of Real Food Price Changes(Annual % Change of Real Price)

Jan.81-Nov.85 Dec.85-Jan.97 Feb.97-Dec.99Jan.00-Aug.02 Sep.02-Mar.08


6

Real Food Price Changes(Proportion of Time Above Threshold)


0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.80 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38

Threshold

Pro

porti

on a

bove

Thr

esho

ld .

Jan. 81 - Nov. 85Dec. 85 - Jan. 97Feb. 97 - Dec. 99Jan. 00 -Aug. 02Sept. 02 -Mar. 08

A

B


7

Real Food Price Changes(Mean Above Threshold)


0

2

4

6

8

10

12

140 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38

Threshold

Con

ditio

nal m

ean

Jan. 81 - Nov. 85Dec. 85 - Jan. 97Feb. 97 - Dec. 99Jan. 00 -Aug. 02Sept. 02 -Mar. 08A

B


8

Real Crude Oil Price Changes(Annual % Change of Real Price)



-100

-50

0

50

100

150

200

Jan-

81

Jan-

83

Jan-

85

Jan-

87

Jan-

89

Jan-

91

Jan-

93

Jan-

95

Jan-

97

Jan-

99

Jan-

01

Jan-

03

Jan-

05

Jan-

07

Crude Oil

Mean per regime

9


150

100

50

0

-50

Jan.81-Jan.87 Feb.87-Jul.91 Aug.91-Mar.99 Abr.99-Mar.08

Distribution of Real Crude Oil Price Changes(Annual % Change of Real Price)


10


Regimes

I -9.79 8.33 9.30 59 Jan-81 Nov-85

II -1.74 7.26 18.77 134 Dec-85 Jan-97

III -12.48 3.82 -5.52 35 Feb-97 Dec-99

IV -2.58 3.75 5.14 32 Jan-00 Aug-02

V 7.57 10.02 37.96 67 Sep-02 Mar-08

PeriodMean s.d. Duration (months)

Max.

Food(Annual % Change of Real Price)

Regimes

I -16.47 16.29 2.18 73 Jan-81 Jan-87

II 11.12 29.36 91.11 54 Feb-87 Jul-91

III -8.19 19.03 40.53 92 Aug-91 Mar-99

IV 23.83 33.34 144.75 108 Apr-99 Mar-08

Max. Duration (months)

PeriodMean s.d.

Crude Oil(Annual % Change of Real Price)

Outline




12

As is well-known in the economic literature (e.g. Clarida, Gali and Gertler, 1999; Walsh, 2003; Woodford, 2003; and others) the optimal monetary policy response to any shock is the solution to a problem where:

The policy maker minimizes a quadratic loss function that reflects society’s preferences for inflation and output stabilization.

This optimization is made subject to the structure of the economy, which is typically assumed linear (or log-linear).

In addition, shocks are assumed to follow an AR(1) process with white noise disturbances.

The solution to this problem provides an optimal feedback rule for the monetary policy instrument which will be a linear, time-invariant function of all the variables and shocks that form part of the economy.


13

However, we are not currently in this type of framework:

For many central banks, high inflation may be more costly than low inflation.

The economy seems to behave differently in recessions than in booms (e.g., Hamilton (1989)).

The shocks we are currently facing, as shown above, follow a very complex stochastic process, with regime shifts, time varying variances and extreme values.

In addition, there is uncertainty about the duration of the “high inflation regimes” in commodity prices.

In this context, the optimal response of monetary policy is likely to be non-linear and time-varying, and will tend to focus on risk management.


14

Following the risk management approach, the response to this environment should be preemptive, significant and transparent:

Failure to act timely may lead to a contamination of the price-setting process; in particular, may affect the formation of inflation expectations.

The response has to be strong, as central banks may prefer to insure against low probability, costly outcomes.

The central bank has to clearly explain the rationale for its policy actions.

But, as we will now see, how preemptive and strong the response should be, depends on the particular circumstances of each economy.


15

2005 – 2007 Inflation Change and Inflation Persistence


Source: WEO, IMF. Calculations by Banco de México.

UKPor

Can

Jap Ire

SpaGre

FraIta

GerHK

USAKorTai

Sin

Mal

Tha

Phi

Ind

-8

-6

-4

-2

0

2

40.

00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

0.90

1.00

Inflation Persistence

Cha

nge

in In

flatio

n fro

m 2

005

to 2

007

ColPan

Sal

ChiPar

MexEcu

Arg

Gua

Bra

Jam

CR

Peru

Nic

VenUruBol

All Countries

Only LA

16



2005 – 2007 Inflation Change and Low Inflation Regime

IndPhil

Thai

HKSin

Gre

Por

Mal

Ire

Spa

Ita

Fra

CanGer

Jap

USATai

UKKor

-8

-6

-4

-2

0

2

40 5 10 15 20 25 30

Duration of Low Inflation Periods (Years)

Cha

nge

in In

flatio

n fro

m 2

005

to 2

007

VenUru

PeruPar

Pan

Bol

Mex

Col Chi

Bra

Bol

Arg

Ecu

Sal

Gua

Jam

Nic

All Countries

Only LA

17

2005 – 2007 Inflation Change and CPI Food Weights



PhilInd

Thai

Mal

UKGer Ire

USAKor

SinHK

Por

Gre SpaTai

JapCan

Fra

Ita

-8

-6

-4

-2

0

2

40 10 20 30 40 50 60

CPI Food Weight

Cha

nge

in In

flatio

n fro

m 2

005

to 2

007

Mex ColEcu

PanChiPar

Nic

Gua

VenUru

CR

Peru

Jam

Bra

Bol

Arg

All Countries

Only LA

18

Cumulative Change in Policy Target Rates and Inflation Persistence



Fra

IrePor

UKJap

Can

USA

KorGer

Thai

Mal

HK

Ind

GreSpa

Ita

-700

-600

-500

-400

-300

-200

-100

0

100

200

300

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

Inflation Persistence

Cum

ulat

ive

Cha

nge

in P

olic

y R

ate

(Bas

isP

oint

s)

CR

PeruGua

Bra

ChiUru Col

Mex

All Countries

Only LA

19Source: WEO, IMF. Calculations by Banco de México.

Cumulative Change in Policy Target Rates and Low Inflation Regime

Jap

ThaCan

KorFraIrePor

HK

USA

UK

GreMal

GerItaSpa

Ind

-700

-600

-500

-400

-300

-200

-100

0

100

200

300

0 5 10 15 20 25 30

Duration of Low Inflation Periods (Years)

Cum

ulat

ive

Cha

nge

in P

olic

y R

ate

(Bas

is P

oint

s)

GuaChi

PerMex

ColUru

Bra

CR


All Countries

Only LA

20



Cumulative Change in Policy Target Rates and CPI Food Weights

ItaIre

US

IndCan

Tha

UK Mal

HK

GerJap

SpaFra

Kor GrePor

-800

-600

-400

-200

0

200

400

6000 10 20 30 40 50 60

CPI Food Weight

Cum

ulat

ive

Cha

nge

in P

olic

y R

ate

(Bas

is

Poi

nts)

Bra

Chi

Uru

GuaPer

CR

Col

Mex

All Countries

Only LA

21

The optimal monetary policy response to “creeping inflation” depends on each country’s particular circumstances:

The inflationary history of the country and, in particular, the extent to which a low inflation equilibrium has been sustained.

The weight that food and energy goods have on the CPI.

The degree of persistence that each economy’s inflation process exhibits to price shocks.

The phase of the cycle the country is located in.

The impact of the current environment on the country’s terms of trade.


22

The evidence suggests that the impact on inflation levels and inflation volatility of the worldwide shocks we have observed in the past years tends to be heterogeneous across countries. In particular:

Inflation seems to have responded more to the price shocks in countries that still exhibit a higher degree of inflation persistence.

Inflation volatility seems to be larger in those countries where the weight of foodstuffs in their consumer prices is higher, as well as in countries where the attainment of a low inflation equilibrium has been more recent.


23

Thus, the same external shocks may imply different monetary responses in different countries, given their own specific characteristics.

In particular, countries that face higher risks of suffering large inflation increases and price volatility (due to their consumption baskets and their inflation history) may have found themselves in the need to respond more aggressively to the current price shocks than other countries.

Indeed, the evidence does suggest that countries that are more vulnerable in these terms have acted accordingly, by restricting their monetary policy stance.


24

Given the evidence in the first part of this talk, a relevant question we should try to address with more research is: for how long will we be facing the current high commodity inflation regime?

Up to this point, the discussion has centered on the policy responses to the current environment, given the policy frameworks that the central banks currently have.

The answer to the question posed above could nonetheless have implications for the issue of whether central banks should rethink the definition of their monetary policy objectives.


Outline




26

Creeping inflation from the current shocks to energy and food prices may imply a restrictive bias in the monetary policy stance:

This is especially true in countries where inflation is persistent, the low inflation equilibrium has not been sustained for a long time and where food and energy have a large weight in consumers’ spending.

This, in turn, reflects the high costs that a breakdown of expectations-based nominal anchors that sustain the low-inflation equilibrium may have on these economies’ performance.

Indeed, some countries may face a combination of the above mentioned features that may lead them to maintain a restrictive bias in their monetary policy, even when they may be currently facing the low phase of their business cycle.


27

The issues raised above focus on the implications of this high inflation regime for monetary policy.

We have to ask to what extent we need to consider a more broad view of the policy response that we should undertake, given this environment. In particular we need to ask:

Which other policy instruments are available to face the current environment?

What is the optimal mix of policy responses to this environment, in order to minimize negative effects on welfare?


28

The policy mix clearly depends on the structure of each economy and on the shocks that each country has faced:

Those who faced an improvement in terms of trade may use specific policies to redistribute the aggregate gains of the shocks to those groups that may have been hurt from price changes.

Those that have faced a terms of trade deterioration also need to determine the optimal policy mix to minimize the welfare costs of this shock.


29

Fiscal policy

May be helpful to redistribute losses (or gains, if terms of trade have improved), across different economic agents.

Competition policy

A non-competitive environment may exacerbate the impact of price shocks on domestic markets. Thus, antitrust agencies should avoid collusive practices in this environment of high price increases.


30

Real Crude Oil Price Changes(Proportion of Time Above Threshold)

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.80 8 16 24 32 40 48 56 64 72 80 88 96 104

112

120

128

136

144

Threshold

Pro

porti

on a

bove

Thr

esho

ld .

Jan. 81 - Jan. 87

Feb. 87 - Jul. 91

Aug. 91 - Mar. 99

Apr. 99 -Mar. 08


Appendix

31

Real Crude Oil Price Changes(Mean Above Threshold)

0

10

20

30

40

50

600 8 16 24 32 40 48 56 64 72 80 88 96 104

112

120

128

136

144

Threshold

Con

ditio

nal M

ean

Jan. 81 - Jan. 87Feb. 87 - Jul. 91

Aug. 91 - Mar. 99Apr. 99 -Mar. 08


Appendix

May 8th, 2008 Creeping Inflation: How much of a concern? What should the response be? XXVII Meeting...

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