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This training material is the property of the International Monetary Fund (IMF) and is intended for use in IMF
courses. Any reuse requires the permission of the IMF.
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
Inflation expectations
Household demand
Corporate demand
Domestically-Generated 𝝿
deposits
loans
MTM: Interest Rate Channel
Monetary Policy
Framework
CPI inflation
Central Bank Policy Rate
Bank lending rates and
credit conditions
Inflation expectations
Household demand
Corporate demand
Net external demand
Exchange rate
Import prices
Domestically-Generated 𝝿
deposits
loans
MTM: Exchange Rate Channel
Monetary Policy
Framework
CPI inflation
Central Bank Policy Rate
Term structure,
asset prices and capital
market conditions
Bank lending rates and
credit conditions
Inflation expectations
Household demand
Corporate demand
Net external demand
Exchange rate
Import prices
Domestically-Generated 𝝿
deposits
loans
MTM: Asset Price Channel
Monetary Policy
Framework
CPI inflation
Central Bank Policy Rate
Term structure,
asset prices and capital
market conditions
Asset purchase/ sales (QE)
Bank lending rates and
credit conditions
Inflation expectations
Household demand
Corporate demand
Net external demand
Exchange rate
Import prices
Domestically-Generated 𝝿
deposits
loans
MTM: Quantitative Easing
Monetary Policy
Framework
CPI inflation
Macro prudential
policy
Central Bank Policy Rate
Term structure,
asset prices and capital
market conditions
Asset purchase/ sales (QE)
Bank lending rates and
credit conditions
Inflation expectations
Household demand
Corporate demand
Net external demand
Exchange rate
Import prices
Domestically-Generated 𝝿
deposits
loans
Macroprudential Policy
Monetary Policy
Framework
CPI inflation
Macro prudential
policy
Central Bank Policy Rate
Term structure,
asset prices and capital
market conditions
Asset purchase/ sales (QE)
Bank lending rates and
credit conditions
Inflation expectations
Household demand
Corporate demand
Net external demand
Exchange rate
Import prices
Domestically-Generated 𝝿
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
Inflation Expectations Approach
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
Inflation Expectations Approach
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