L-4 Analyzing Inflation and Assessing Monetary Policy - Inflation and...•Energy prices...

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L-4

Analyzing Inflation and Assessing

Monetary Policy

Presenter

Reza Siregar

IMF − Singapore Regional Training Institute

OT 18.52 Macroeconomic Diagnostics February 26 – March 2, 2018

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 and transmission

• Assessing the stance of monetary policy

o Inflation expectations approach

o Real interest rate approach

o Taylor Rule approach

o Yield Curve approach

3

I. Inflation and Its Determinants

4

What is Inflation?

5

Definition

Inflation 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

1,6

3,0

17,1

2,7

5,1

12,2

1,12,9

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

9

• 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

MVP

Y

m v y m v y

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?

15

• 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

16

• 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 y

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 e

t t t t trmc

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

19

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)

21

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

22

• 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

23

• 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

Issue #2: The Transmission Process

24

• Interest Rates

• Monetary Aggregates

• Exchange Rate

• Asset Prices

• Real GDP

• Price Level

Monetary Transmission Mechanism (MTM)

25

• 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 𝝿

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

33

Inflation Expectations Approach

34

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


35

• 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 public

o Central bank uses policy levers to move inflation towards its target, thus managing inflation expectations

o Expected inflation is the only basis for assessment of the stance of policy


36

• 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

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

40

• 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

1

e

t t t t ti r E rp

Nominal interest rate

Real interest rate

Expected inflation

Risk premia

41

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

42

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

43

• 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

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

44

• Taylor’s original estimation:

• Forward-looking version

– Where is called a policy neutral rate

– And where

tttt yi ˆ5.0)2(5.02 Coefficient must be higher

than zero – Taylor principle

tt

e

t

n

tt yffii ˆ)( 211

e

t

n

t ri 1

5.0,5.1 21 ff

Inflation Targeting Rule

45

• 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

t

e

t

n

tt fii )( 11

e

t

n

t ri 1

Stance of Monetary Policy

46

• 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 tight

Where 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 tight

Where iitg is interest rate derived from inflation targeting rule

A Timing Issue

47

• 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 rate

III. 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

48

• 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

49

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

50

• 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

51

• 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

1

e

t t t t ti r E rp

Interpreting an Upward Sloping Yield Curve

52

• 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

53

Dec-09

4,4

4,7

5,04,9

1,5

2,0

2,5

3,0

3,5

4,0

4,5

5,0

5,5

3-Months

Maturity

6-Months

Maturity

1-Year

Maturity

3-Year

Maturity

5-year

Maturity

7-year

Maturity

10-year

Maturity

15-year

Maturity

20-year

Maturity

30-year

Maturity

Yie

ld (

% p

.a)

Dec-07 Dec-09 Dec-11

Dec-13 Dec-15 Sep-17

Malaysia

Key Takeaways

54

• 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

55

Thank you!

56

Appendix

Inflation Expectations

57

• 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 (𝜋𝑡

𝑒 = 𝜋𝑇)

– Recent inflation (𝜋𝑡𝑒 = 𝜋𝑡−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

L-4 Analyzing Inflation and Assessing Monetary Policy - Inflation and...•Energy prices...

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