Monetary Policy · equilibrium value for the real interest rate. • An example: the trend of real...

Monetary Policy

The views expressed herein are those of the author and should not be attributed to the IMF, its Executive Board, or its management.

Bank Indonesia International Workshop and SeminarCentral Bank Policy Mix: Issues, Challenges and Policies

Jakarta, 9-13 April 2018Stephan Danninger

Inflation and Monetary Policy

2

• Among key goals of economic policymakers are low inflation and low unemployment – sometimes goals conflict

• In the short run, if policymakers try to expand aggregate demand (using monetary or fiscal policy) they will tend to increase output (decrease unemployment) and raise the inflation rate

• Ability to assess inflation and monetary policy stance are, therefore, critical in limiting potential conflicts between the two key macroeconomic policy objectives

Lecture Outline

• Inflation and Its Determinants

• Monetary policy, regimes, and transmission

• Assessing the stance of monetary policy

o Inflation expectations approacho Real interest rate approacho Taylor Rule approacho Yield Curve approach

3

I. Inflation and Its Determinants

4

What is Inflation?

5

DefinitionInflation is the rise in the general level of prices of goods and services in an economy over a period of time– When positive inflation– When negative deflation

• Consumer Price Index (CPI)– Headline CPI Inflation– Alternative CPI measures (e.g. core inflation)

What is the Difference Between Headline and Core Inflation?

6

• Headline inflation is the total movement of prices• Core inflation is supposed to be the long-run, less volatile,

component of CPI• Core inflation reflects general inflationary pressures in the

economy – it excludes some components• Energy• Food• Regulated prices

• No firm theoretical basis; no generally agreed approach to measuring core inflation

CPI Weights: United States

7

8

CPI Weights: Cambodia

44.8

1.63.0

17.1

2.7

5.1

12.2

1.1

2.9 1.2

5.92.3 Food & Non Alcoholic Beverage

Alcoholic Beverage, Tobacco & Narcotics

Clothing & Footwear

Housing & Utilities

Furnishing & Household Maintenance

Health

Transportation

Communication

Recreation & Culture

Education

Restaurants

Miscellaneous Goods & ServicesSource: CEIC Data Co.

Core Inflation: Permanent Exclusions

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• Depends on the purpose• Forecasting accuracy

• Tax changes• Regulated• Energy• Food

• Decision making• Tax changes – yes• Energy prices – questionable• Food prices – highly questionable

• Typically a large part of the basket• Huge spillovers to the rest

Core Inflation: Country Examples

10

Country Official Core Measure

Malaysia CPI excluding Food and Energy

Canada CPI excluding Food, Energy and Indirect Taxes

Thailand CPI excluding Fresh Food and Energy (23%)

Chile CPI excluding 20% with higher (-) variations and 8% with higher (+) variations

New Zealand (90s) CPI excluding interest charges

Singapore CPI excluding costs of private road transport and costs of accommodation

Japan CPI excluding Fresh Food

Peru CPI excluding 9 volatile items (food, fruits and vegetables, and urban transport, about 21.2 %)

United States CPI excluding food and energy

United Kingdom Retail price index excluding mortgage interest rates (RPIX)

Contributions to CPI

11

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0Thailand: Contributions to CPI

Transport & Communication(TC)

Food & Beverages (FB)

Clothing & Footwears (CF)

Housing & Furnishing (HF)

Health & Personal Care (HP)

Recreation, Reading,Education and Religion (RR)

Tobacco & AlcoholicBeverages (TA)

Thai CPI (% change OYA)

Comparing Headline and Core CPI Inflation

12

Source: Haver Analytics

-6.0

-3.0

0.0

3.0

6.0

9.0

Jan-2006 Jan-2007 Jan-2008 Jan-2009 Jan-2010 Jan-2011 Jan-2012 Jan-2013 Jan-2014 Jan-2015 Jan-2016 Jan-2017

Malaysia: Headline vs. Inflation Excluding Food and Energy

Headline Inflation CPI excluding Food and Energy (YoY)

Long-run Determinants of Inflation

“Inflation is always and everywhere a monetary phenomenon” ~ M. Friedman

• Quantity theory is the general theory of inflation

where M:money, P:prices, Y:output, V:velocity

• Constant velocity and money neutrality -> inflation follows money growth

• In the long run, periods of hyperinflation• Less so in the short run in normal times

MVPY

m v y m v yπ π

=

∆ + ∆ = + ∆ ⇒ = ∆ + ∆ − ∆

Short-run Inflation: Why Care?

14

• Important to understand what determines inflation in short-run

• Even temporary shock could ignite inflation spiral• Example: oil price ↑ -> cost of production ↑ -> prices

of goods ↑ -> demand for higher wages ↑ -> labor cost ↑ …

• Also through inflationary expectations

What are Possible Short-run Determinants of Inflation?

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• Past inflation (hysteresis)• Expectations• Domestic demand and supply pressures

• Business cycle factors (Phillips curve)• Market structure• Indirect taxes

• External spillovers• Import prices• Commodity prices• Exchange rate movements

Phillips Curve

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• Expected Inflation (πE)• Deviations of unemployment from the natural rate

or the output gap - demand shocks • Other shocks, in particular supply shocks (εt)

( )ty y−

( )E

t t ty yπ απ δ ε= + − +

Augmented New-Keynesian Phillips curve

17

• Prices are set via both backward and forward looking expectation

• E.g. a subset of firms set prices according to a backward-looking rule of thumb (contracts, wages)

• Transmission mechanism in real marginal cost (rmc)• Demand rises• Firms respond and produce more (no shortage on the market)• However, firms face increasing marginal costs• Firms must ask for higher price

Change in realmarginal cost

( )1 11 et t t t trmcπ απ α π β ε− += + − + +

Components of Real Marginal Costs

18

• Real marginal cost (rmc) can be approximated as a function of:Domestic producers- Output gap, unemployment gap - Real wage gap if real wages are counter-cyclical

Importers- Real exchange rate gap- Or import prices gap

II. Monetary Policy and Transmission

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Compatible choices

20

Countries need to choose:

A monetary policy strategy (e.g. inflation targets or money growth targets)

An exchange rate arrangement

Type of management of international capital flows

The choices must be compatible!

Trilemma (Mundell, 1963)

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TRILEMMA

Monetary Autonomy

Exchange Rate Stability

Capital Mobility

Inflation TargetMonetary Target

Fixed exchange rates:Monetary union,Currency board

Fixed exchange rates with capital controls

Interest rate parity

Two Important Issues

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• As one evaluates monetary policy, two important issues must be kept in mind:– Issue #1: What is the monetary policy regime – what is

the central bank saying and what is it actually doing?

– Issue # 2: What is the transmission mechanism of monetary policy?

Issue #1: The Monetary Policy Regime

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• The policy regime is the framework used by the monetary authorities to influence the evolution of macro variables

• The nominal anchor is the publicly-announced variable that serves as the long-run target for monetary policy

• Instruments are the facilities that central banks employ to achieve the target(s)

• Commitment to the framework is important to building credibility (making the CB accountable to achieving stability helps anchor inflation expectations)

• Effective communication strategy is essential

Possible Monetary Policy Regimes

24

Monetary Policy Regimes around the World

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Issue #2: The Transmission Process

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• Interest Rates

• Monetary Aggregates

• Exchange Rate

• Asset Prices

• Real GDP

• Price Level

Monetary Transmission Mechanism (MTM)

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• Understanding the MTM is essential for monetary policy design and calibration.

• To determine the nature of the transmission mechanism in a specific country requires: Monitoring the response of key variables / markets Modeling the dynamics and identifying time lags Gauging the projected quantitative response to Monetary

Policy decisions

Monetary Policy

Framework

CPI inflation

Inflation expectations

Domestically-Generated 𝝿𝝿

MTM: Inflation Expectations Channel

Monetary Policy

Framework

CPI inflation

Central Bank Policy Rate

Bank lending rates and

credit conditions


Household demand

Corporate demand


deposits

loans

MTM: Interest Rate Channel

Monetary Policy

Framework

CPI inflation



credit conditions


Household demand

Corporate demand

Net external demand

Exchange rate

Import prices


deposits

loans

MTM: Exchange Rate Channel

Monetary Policy

Framework

CPI inflation


Term structure,

asset prices and capital

market conditions


credit conditions


Household demand

Corporate demand

Net external demand

Exchange rate

Import prices


deposits

loans

MTM: Asset Price Channel

Monetary Policy

Framework

CPI inflation


Term structure,


market conditions

Asset purchase/ sales (QE)


credit conditions


Household demand

Corporate demand

Net external demand

Exchange rate

Import prices


deposits

loans

MTM: Quantitative Easing

Monetary Policy

Framework

CPI inflation

Macro prudential

policy


Term structure,


market conditions



credit conditions


Household demand

Corporate demand

Net external demand

Exchange rate

Import prices


deposits

loans

Macroprudential Policy

Monetary Policy

Framework

CPI inflation

Macro prudential

policy


Term structure,


market conditions



credit conditions


Household demand

Corporate demand

Net external demand

Exchange rate

Import prices


deposits

loans

Central Bank Communication

MTM: The Role of Communications

III. Assessing the Stance of Monetary Policy

35

Inflation Expectations Approach

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Expected inflation may be:

• Estimated from surveys of market participants, households and firms

• Inferred from interest rates on otherwise similar inflation-indexed (and non-indexed) bonds; i.e. market-based instruments


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• Inflation expectations are said to be well anchored if they approach the central bank inflation πT over some horizon I

Et π t+I -> πT

• Horizon: 2 to 10 years but varies by country• Implicit assumptions:

o Commitment to an inflation target o Target known to the publico Central bank uses policy levers to move inflation towards

its target, thus managing inflation expectationso Expected inflation is the only basis for assessment of the

stance of policy


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• The following conditions suggest that monetary policy is

o Neutral if Et π t+i = πT

o Tight or not sufficiently loose if Et π t+i < πT

o Loose or not sufficiently tight if Et π t+i > πT

Are Inflation Expectations Well Anchored in Advanced Economies?

Intercept falling to zero Slope falling to zero

Source: WEO (2013), “The Dog that Didn’t Bark: Has Inflation Been Muzzled or Was it Just Sleeping,” April, chapter 3.

t*

t*

itt )(E ε+π−πβ+α=π−π +Under the H0 of well anchored expectations : α=β=0

U.S. Inflation Expectations—Comparing Indexed and Non-Indexed Securities

-2.0%

0.0%

2.0%

4.0%

6.0%

U.S. Inflation Expectations

10Y Treasury Inflation-Indexed Security, Constant Maturity

10Y Treasury, Constant Maturity

Source: Bloomberg

Korea: Inflation Expectations

Source: Consumer Survey Index Inflation Expectations, Bank of Korea

Real Interest Rate Approach

42

• Fisher equation

• Note problems in measuring rt

– Expected inflation is unobserved– Risk premia is unobserved

• Nevertheless the real interest rate may be used to evaluate the stance of monetary policy

1e

t t t t ti r E rpπ += + +

Nominal interest rate

Real interest rate

Expected inflation

Risk premia

43

Was Monetary Policy in Korea Tight in 2007?

• How can we make this assessment using the information we have about the real interest rate?

SSource: Haver Analytics; Bloomberg

-2

0

2

4

6

8

10

12

14

Q4-2000

Q4-2002

Q4-2004

Q4-2006

Q4-2008

Q4-2010

Q4-2012

Q4-2014

Q4-2016

Real Central Bank Overnight Policy Rate

Real Central Bank Policy Rate

44

Measuring the Real Interest Rate “Gap” in Korea

• Estimate a long-run equilibrium value for the real interest rate.

• An example: the trend of real interest rate.

• Deviations from the trend, or “gaps” can signal the stance of policy:

• r - r > 0 policy tight• r - r < 0 policy loose

SSource: Haver Analytics; Bloomberg

-2

0

2

4

6

8

10

12

14

Q4-2000

Q4-2002

Q4-2004

Q4-2006

Q4-2008

Q4-2010

Q4-2012

Q4-2014

Q4-2016

Real Central Bank Overnight Policy Rate

Real Central Bank Policy Rate Neutral Real Interest Rate (r*)

The Taylor Rule

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• Taylor (1993) defines interest rate rule relating fed funds rate with steady state real interest rate and inflation gap and output gap.

• General form:

tt2t1tt yc)(cri επππ ++−++=

Inflation

Central bank or short-term money market interest rate

Short-term trend real interest rate

Explicit or implicit definition of price stability

Output gap

The Taylor Rule

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• Taylor’s original estimation:

• Forward-looking version

– Where is called a policy neutral rate

– And where

tttt yi ˆ5.0)2(5.02 +−++= ππCoefficient must be higher than zero – Taylor principle

ttet

ntt yffii εππ ++−+= + ˆ)( 211

et

nt ri 1++= π

5.0,5.1 21 == ff

Inflation Targeting Rule

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• A version of the forward-looking Taylor rule without the output gap :

– Where is the policy neutral rate

• Not very realistic; even the inflation targeting central banks care to some extent about the output gap

tet

ntt fii εππ +−+= + )( 11

et

nt ri 1++= π

Stance of Monetary Policy

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• To assess the stance of current policy using a Taylor rule one compares actual rate with derived Taylor rate:– If icurrent - itr < 0 then monetary policy was too loose– If icurrent - itr > 0 then monetary policy was too tightWhere itr is interest rate derived from Taylor rule

• To assess the stance of current policy using inflation targeting rule one compares actual rate with derived rate:– If icurrent - iitg < 0 then monetary policy was too loose– If icurrent - iitg > 0 then monetary policy was too tightWhere iitg is interest rate derived from inflation targeting rule

A Timing Issue

49

• Taylor Rule looks easy and is a good starting point• But when assessing the monetary policy stance

I. There is the problem of real-time output gap estimation o Output gap estimation may be imprecise

II. Same applies for the trend real interest rateIII. But mainly, reaction to the observed inflation leaves you

behind the curve – one reacts too late

• Hence a forecast for inflation is needed– Use financial market expectations with caution—influenced

by and in turn influence the stance of monetary policy

Taylor Rule in Pre-Crisis Fed Policy

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• Easy monetary policy in 2001-2005

• Actual interest rate (federal funds rate) below that implied by the Taylor rule

Summarized inTHE FINANCIAL CRISIS AND THE POLICY RESPONSES AN EMPIRICAL ANALYSIS OF WHAT WENT WRONGNBER Working Paper 14631

SSource: The Economist, http://www.economist.com/node/9972453

Bernanke’s Response

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Source: Ben Bernanke: „ Monetary Policy and the Housing Bubble ", At the Annual Meeting of the American Economic Association, Atlanta, Georgia, January 3, 2010.

Yield Curve and Pure Expectations

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• A yield curve may be used as a leading indicator of economic conditions

• In order to interpret the yield curve, we need a theory of how interest rates for various maturities are determined

• The simplest theory is the expectations theory which holds that the slope of the yield curve reflects only investors' expectations for future short-term interest rates.

• The pure expectations theory predicts

– that yields on various maturities move together.

– the yield curve is slightly upwardly sloped.

Yield Curve and Risk Premium

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• Recall the Fisher equation

• The risk premium compensates the bond holder for risksassociated with unexpected inflation (inflation risk premium) and risks associated with holding a longer-term asset (term premium)

• Changes in the yield curve reflect changes in– Risk (term) premium– Expected inflation– Expected monetary policy

• Correlated with first two factors

1e

t t t t ti r E rpπ += + +

Interpreting an Upward Sloping Yield Curve

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• A steep upward sloping yield curve could mean any of the following:– The risk premium is larger in period 2

– Monetary policy is relatively loose in period 1

– Inflation is expected to be higher in period 2

• How the (slope of) yield curve changes over time is important in assessing the stance of policy

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Dec-09

4.4

4.7

5.0 4.9

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

3-MonthsMaturity

6-MonthsMaturity

1-YearMaturity

3-YearMaturity

5-yearMaturity

7-yearMaturity

10-yearMaturity

15-yearMaturity

20-yearMaturity

30-yearMaturity

Yiel

d (%

p.a

)

Dec-07 Dec-09 Dec-11

Dec-13 Dec-15 Sep-17

Government Bond Yield Curves 2007-2016 (Q4 Average % p.a)

Malaysia

Key Takeaways

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• Understanding inflation is complicated• Understanding the MTM is key to the design and calibration of

monetary policy• To analyze the stance of monetary policy there are different

diagnostic tools – Inflation Expectation Approach– Real Interest Rate Approach– Taylor Rule and Inflation Targeting Rule– Yield Curve

• Each tool has pros and cons

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Thank you!

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Appendix

Inflation Expectations

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• Help stabilize inflation, but can also destabilize it• Even temporary shocks can have long-lasting effects on inflation

• Are determined by:• Credibility of monetary and fiscal policy (𝜋𝜋𝑡𝑡𝑒𝑒 = 𝜋𝜋𝑇𝑇)• Recent inflation (𝜋𝜋𝑡𝑡𝑒𝑒 = 𝜋𝜋𝑡𝑡−1) – adaptive expectations• Long-run trend/”natural” level of inflation

• Are not observable → Surveys• Households, business, official forecasters and market analysts

• Financial data

Malaysia: Inflation Expectations

Source: Consumer Survey Index Inflation Expectations, Bank of Korea

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

Expected Inflation (One-year ahead) CPI Inflation, %y/y

Source: Haver Analytics, IMF WEO Outlook

Monetary Policy · equilibrium value for the real interest rate. • An example: the trend of real...

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