Hubert Kempf

Economic policies

Master in economics

Lecture 11
Inflation and monetary policy

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)

40

35

30

25

20

15

10

0 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

16 14 12 10 8 6 4 2 0
71 19 73 19 75 19 77 19 79 19 81 19 83 19 85 19 87 19 89 19 91 19 93 19 95 19 97 19 99 20 01 20 03 20 05

-2
19

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)
3,5 3
percentages

2,5 2 1,5 1 0,5 0

01 -1 99 9 01 -2 00 0 01 -2 00 1 01 -2 00 2 01 -2 00 3 01 -2 00 4 01 -2 00 5

Inflation

Underlying inflation

Inflation persistence in the Euro Area Macro evidence

t a0 ( L) t 1 au ut

(L)1 2 L3 L2 ....

: Inflation de LT

a0 * 1,9% 1 (1)

0.40

Dependent Variable: Method: Least Squares Date: 02/10/05 Time: 10:38 Sample (adjusted): 1995M01 2004M12 Included observations: 120 after adjustments Variable (-12) Coefficient 0.659205 Std. Error 0.090646 t-Statistic 7.272268 Prob. 0.0000

(-24)
C R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood

-0.251187
1.176806 0.323390 0.311824 0.437358 22.38002 -69.51323

0.073918
0.152120 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic

-3.398205
7.736041

0.0009
0.0000 1.977511 0.527215 1.208554 1.278241 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 ( la Blinder, 1998)
Based on Price Setting in the euro area: Some stylised facts from Individual Consumer Price Data by Dhyne, lvarez, Le Bihan, Veronese, Dias, Hoffmann, Jonker, Lnnemann, 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

Stylized Facts
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)

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

30
(months)

25

20

United States

15

10

0 0 5 10 15 20 25 (months) 30

euro area

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.

0.6

Frequency of price decreases

0.45

0.3

0.15

0 0 0.15 0.3 0.45 0.6 Frequency of price increases

0.5

Size of price decreases

0.375

0.25

0.125

0 0 0.125 0.25 0.375 0.5 Size of price increases

Fact 4: Cross-product heterogeneity is substantial

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%).

Frequency of price increases and price decreases Euro area figures in p.c. (using HICP weights)
Unprocessed food Processed food Energy Non-energy industrial goods Services

Total

Frequency of price changes Frequency of price increases Frequency of price decreases Share of price increases

0.28

0.14

0.78

0.09

0.06

0.15

0.15

0.07

0.42

0.04

0.04

0.08

0.13

0.06

0.36

0.03

0.01

0.06

0.54

0.54

0.54

0.57

0.80

0.58

Distribution of the frequency of price changes

0.20 0.18 0.16
Density (in p.c.)

0.14 0.12 0.10 0.08 0.06 0.04 0.02 0.00

[0.6; 0.62) [0.7; 0.72) [0.8; 0.82) [0; 0.02) [0.9; 0.92) [0.5; 0.52) [0.4; 0.42) [0.1; 0.12) [0.2; 0.22) [0.3; 0.32)

Frequency of price changes (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 at be de es fi fr it lu nl pt euro min 0.12 0.09 0.06 0.06 0.16 0.09 0.08 0.19 0.09 0.11 0.08 median 0.21 0.18 0.13 0.15 0.36 0.19 0.24 0.48 0.27 0.17 0.18 max 0.85 0.86 0.44 0.45 1.00 0.78 0.60 1.00 1.00 0.90 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

0.35

VAT increase
0.3

VAT decrease

Euro cash changeover

0.25

0.2

0.15

0.1

0.05

0
m 8 m 1 19 2 95 m 4 19 95 m 8 19 95 m 1 19 2 96 m 4 19 96 m 8 19 96 m 1 19 2 97 m 4 19 97 m 8 19 97 m 1 19 2 98 m 4 19 98 m 8 19 98 m 1 19 2 99 m 4 19 99 m 8 19 99 m 1 20 2 00 m 4 20 00 m 8 20 00 m 1 20 2 01 m 4 20 01 m 8 20 01 m 1 20 2 02 m 4 20 02 m 8 20 02 m 12 19 94 19 94

total (incl. replacements)

increases

decreases

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

1.3 - Monetary policy implications

To recap :
1) Euro area has been hit by a series of costpush 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 costpush 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

Policy implications (2) 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)

Policy implications (3) 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

1 - Monetary policy framework Rule-based Discretion

Currency Exchange Crawling Inflation Board Rate peg peg targeting

Monetary Multiple targeting mandate

2 - communication

Simple

Complex

Exchange Rate Regime

Monetary Policy Framework Monetary aggregate target Inflation targeting framework IMFsupported mon. Prog.

Exchange rate anchor Exchange arrangements with no separate legal tender (41) Another currency as legal tender (9) CFA franc zone (14)

Other Euro area (12)3 Austria Belgium Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain

Ecuador El Salvador4 Kiribati Marshall Islands Micronesia, Fed. States of Palau Panama San Marino Timor-Leste

ECCU (6)2 Antigua and Barbuda Dominica* Grenada St. Kitts and Nevis St. Lucia St. Vincent and the Grenadines

WAEMU CAEMC Benin Cameroon* Burkina Faso* Central Cte d'Ivoire* Guinea-Bissau Mali* Niger Senegal* Togo African Rep. Chad Congo, Rep. of Equatorial Guinea Gabon*

Bosnia and Herzegovina Currency board Brunei Darussalam arrangements (7) Bulgaria China-Hong Kong SAR Djibouti Estonia9 Lithuania9

Exchange Rate Regime

Monetary Policy Framework Monetary aggregate target China, P.R.of6 Inflation targeting framework IMFsupported mon. Prog.

Other conventional fixed peg arrangements (42)

Against a single currency (34)

Exchange rate anchor Against a composite (8)

Other

Aruba Bahamas, The Bahrain, Kingdom of Barbados Belize Bhutan Cape Verde* China,P.R.of6 Comoros7 Eritrea Guinea6 Iraq 6 Jordan*6 Kuwait Lebanon6 Lesotho* Macedonia, FYR*6 Malaysia Maldives Namibia Nepal* Netherlands Antilles Oman Qatar Saudi Arabia Seychelles6 Suriname5,6 Swaziland Syrian Arab Rep.5 Turkmenistan6 Ukraine*6 United Arab Emirates Venezuela, Rep. Bolivariana de Zimbabwe6
5

Botswana5 Fiji Latvia Libyan Arab Jamahiriya Malta Morocco Samoa Vanuatu

Exchange Rate Regime

Monetary Policy Framework Monetary aggregate target Inflation targeting framework Hungary IMFsupported mon. Prog.

Pegged exchange rates within horizontal bands (5) 8 Crawling pegs (6)

Exchange rate anchor Within a cooperative Other band arrangement (2) arrangements (3) Cyprus Denmark9 Slovenia9 Bolivia* Costa Rica Honduras*6 Nicaragua* Solomon Islands6 Hungary Tonga

Other

Tunisia

Honduras*6

Tunisia Exchange rates Belarus within Romania6 Managed floating with no predetermined path for the exchange rate (48)

Bangladesh* Cambodia5 Egypt5 Ghana*6 Guyana* Indonesia Iran, I.R. of Jamaica6 Mauritius Moldova Sudan Zambia*

Czech Rep. Peru*6 Thailand

Argentina* Azerbaijan* Croatia Ethiopia* Georgia* Haiti3,6 Kenya*

Afghanistan, I.S. of Algeria3 Angola

3

Burundi*3 Gambia, The* 3,6 India3

Kyrgyz Rep.* Kazakhstan3 Mauritania* Lao PDR*5 Mongolia* Mozambique Pakistan* Rwanda* Serbia and Montenegro*11 Tajikistan* Vietnam
6

Myanmar3,5,6 Nigeria6 Paraguay*3 Russian Federation3 So Tom and Prncipe Singapore3 Slovak Rep.3 Trinidad and Tobago Uzbekistan3,5

Exchange Rate Regime

Monetary Policy Framework Monetary aggregate target Malawi* Inflation IMFtargeting supported framework mon. Prog. Other Australia Albania* Dominican Armenia* Congo, Dem. Rep. of* Madagascar* Tanzania* Uganda* Rep.*3 Japan 3 Liberia3,6 Papua New Guinea3 Somalia5,12 Switzerland3 United States3

Exchange rate anchor Independently floating (36)

Sierra Leone*6 Brazil* Sri Lanka* Uruguay* Yemen, Rep. of Canada Chile Colombia* Guatemala Iceland Israel6 Korea Mexico New Zealand Norway Philippines Poland South Africa Sweden Turkey* United Kingdom
5

2.2- Pro and cons of alternative policy regimes

1 - Exchange-rate pegging: from currency board to crawling peg:
Objective: peg the currency to that of a large, low inflation country

Pros
provides an nominal anchor prevents time-inconsistency corrects low credibility

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

monetary policy bound by a rule

simple and clear to communicate can lower inflation quickly

2 Monetary targeting
Objective: money growth as an nominal anchor

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

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

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

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

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!