Is central bank conservatism desirable under learning?

In a New Keynesian model, we consider the delegation problem of the government when the central bank optimally sets discretionary monetary policy taking account of private expectations formed through adaptive learning. Learning gives rise to an incentive for the central bank to accommodate less the effect of inflation expectations and cost-push shocks on inflation and induces thus a deviation from rational expectations equilibrium. However, discretionary monetary policy under learning suffers from an excessively low stabilization bias. To improve the social welfare, the government should appoint a liberal central banker, i.e., set a negative optimal inflation penalty that decreases with the value of learning coefficient. The main conclusions are valid under both constant- and decreasing-gain learning.     

Inflation targeting in a learning economy: An ABM perspective

This paper investigates the performances of an inflation targeting regime in a learning economy framed as an Agent-Based Model (ABM). We keep our ABM as close as possible to the original New Keynesian (NK) model, but we model the individual behaviour of the agents under procedural rationality à la Simon. Accordingly, we assume that their behaviour is guided by simple rules of thumb – or heuristics – while a continuous learning process governs the evolution of those rules. Under these assumptions that also allow the emergence of agents heterogeneity, we analyze the dynamics of the economy without assuming rational expectations, and study the role that a central bank, implementing an inflation targeting regime via a monetary policy rule, can play in the orientation of these dynamics. Consequently, our main goal is to analyse the interplay between the learning mechanisms operating at the individual level and the features and performances of the inflation targeting regime. Our results point to the prime importance of the credibility of central bank's inflation target regarding macroeconomic stabilisation, as well as the beneficial role played by that target as an anchoring device for private inflation expectations. We also establish the potential welfare cost of imperfect public information and contribute to the current debate on optimal monetary policy rules under imperfect common knowledge and uncertainty.     

Financial market imperfections and monetary policy strategy

In a model with imperfect money, credit and reserve markets, we examine if an inflation-targeting central bank applying the funds rate operating procedure to indirectly control market interest rates also needs a monetary aggregate as policy instrument. We show that if private agents use information extracted from money and financial markets to form inflation expectations and if interest rate pass-through is incomplete, the central bank can use a narrow monetary aggregate and the discount interest rate as independent and complementary policy instruments to reinforce the credibility of its announcements and the role of inflation target as a nominal anchor for inflation expectations. This study shows how a monetary policy strategy combining inflation targeting and monetary targeting can be conceived to guarantee macroeconomic stability and the credibility of monetary policy. Friedman's k-percent money growth rule, which can generate dynamic instability, and two alternative stabilizing feedback monetary targeting rules are examined.     

Are speed limit policies robust?

Both price level targeting and speed limit policies have been suggested as alternatives to inflation targeting that may confer benefits when a central bank operates under discretion, even if society’s loss function is specified in terms of inflation volatility. Here we show that price level targeting dominates a speed limit policy under perfect credibility and rational expectations. However, a speed limit policy is more robust than a price level target. Even for small deviations from either rational expectations or perfect credibility, a speed limit policy dominates a price level target.     

The effects of the monetary policy regime shift to inflation targeting on the real interest rate in the United Kingdom

This paper studies the effects of the monetary policy regime shift to inflation targeting on the stochastic properties of the real interest rate in the U.K. The empirical analysis suggests a constant mean of the real interest rate that shifts with the monetary policy regime change to inflation targeting in October 1992. The mean-reverting level of the real interest rate has decreased from 5.1% to 2.3% per annum with the change in monetary policy to inflation targeting. In addition, the shift in monetary policy regime to inflation targeting has reduced the volatility of the real interest rate and increased the persistence of real interest rate deviations from the mean. The results suggest that the central bank can affect the stochastic properties of the real interest rate through the choice of monetary policy regime over a long period of time.     

Reactions of real yields and inflation expectations to forward guidance in the United States

We study the impact of forward policy rate guidance by the Federal Reserve’s Federal Open Market Committee (FOMC) used as an unconventional monetary policy tool at the zero lower bound of the policy rate on real and breakeven US Treasury yield curves. We find that explicit FOMC policy rate guidance announcements led to a significant reduction in real yields at horizons of 2 to 5 years ahead. By contrast, long-term breakeven inflation rates were little affected, suggesting that inflation expectations have remained well anchored, and that explicit FOMC policy rate guidance has not adversely affected central bank credibility.     

The reaction of disagreements in inflation expectations to fiscal sentiment obtained from information in official communiqués

Using official communiqués about fiscal policy, we develop a fiscal sentiment indicator, and we verify the reaction of disagreements in inflation expectations to fiscal sentiment. This analysis is relevant to inflation targeting (IT) countries because transparency and communication can influence expectations. The results suggest that a more optimistic fiscal sentiment reduces disagreements in inflation expectations. Estimates show that, for higher disagreements in inflation expectations at 12-month maturity, an optimistic fiscal sentiment can reduce the disagreement more sharply. In turn, the fiscal sentiment effect on the disagreement for the 48-month maturity is stronger the smaller the disagreement is. The results allow us to outline the following policy recommendations. First, an optimistic fiscal environment is important in the task of guiding inflation expectations and reducing inflation uncertainty. Second, fiscal communication is an important tool for the expectations formation process, and therefore it must be carefully managed to help in the task of forward guidance of inflation expectations, being important for the IT regime. Third, both fiscal credibility and monetary policy credibility are important for the expectations formation process, particularly for the reduction of inflation uncertainty, representing aspects that must be preserved in countries that adopt the IT regime.     

Central bank forecasts and private expectations: An empirical assessment from three emerging economies

As part of their monetary policy strategy, many central banks are attempting to manage private sector expectations about key macroeconomic variables. In this article, we investigate whether forecasts provided by central banks in three inflation targeting emerging economies (Brazil, Mexico, and Poland) affect the expectations of private forecasters. In particular, we analyze whether the disagreement between the central bank and private sector forecasts applies to explain changes in private sector expectations regarding inflation and economic growth. The findings show that while central bank forecasts are higher than those made by private sector forecasters, the result is an update upwards of private forecasts and that this effect is stronger for GDP growth forecasts than for inflation forecasts.     

Public debt indexation and denomination with an independent central bank

This paper examines the interaction between public debt management and the design of monetary institutions. The analysis shows that delegation of monetary policy to an independent central bank is more effective in containing inflationary expectations than the use of foreign currency or inflation-indexed debt. If delegation of monetary policy is viable, the optimal policy is to issue nominal debt. This increases the sensitivity of taxes and output to unexpected inflation, thus minimizing the inflation needed to offset supply shocks. Evidence on central bank independence, debt composition and output variability suggests that the normative argument has some positive content.     

INFLATION TARGETERS IN PRACTICE: A LUCKY LOT?

Some observers have attributed the success of inflation targeters in reducing inflation to the global disinflation of the 1990s. As a result, inflation targeting countries have been considered to be a lucky lot. One key policyimplication of that is that if the international environment becomes again hostile to low inflation in the future, inflation targeting will prove to have been a mere fad. This article views inflation targeting not just as a rule but as a framework for the conduct of monetary policy, and it argues that currently available analyses of the experience of inflation targeting countries have serious weaknesses. One weakness is that those studies have not taken into account that regime changes may alter the quantitative and qualitative interaction among small, open economies and the rest of the world. Another weakness is that those studies have not recognized that the extraction of common trends and cycles is contingent on the nature of the monetary policy regime. It is likely that inflation targeting frameworks may imply a new beneficial trend in monetary policy making. This suggests that if the international environment becomes again hostile to low inflation in the future, an inflation targeting framework may become a viable alternative to a central bank that remains committed to price stability.     

Inflation Targeting as a Framework for Monetary Policy: A Cross-Country Analysis

This study makes use of a dynamic Taylor‐type model to examine the conduct of monetary policy by central banks that profess to engage in inflation targeting. Previous research regarding inflation targeting and Taylor‐type rules is reviewed and a dynamic Taylor‐type model is developed. Tests for regime shifts upon the adoption of inflation targeting indicate a significant change in policy in each of the nations in the study for which sufficient data were available. Next, the central bank reaction functions were estimated. Results suggest that most of the central banks conducted a policy of inflation targeting by seeking to contain inflationary pressures rather than reacting to current inflation.     

On the Future of Inflation Targeting in East Asia

This article analyzes the problems associated with inflation targeting (IT) regimes in a number of East Asian countries. It scrutinizes the policy conflicts that can arise when a central bank that has adopted a formal inflation target to guide the conduct of monetary policy simultaneously manages the exchange rate and pursues financial stability objectives. To this end, it empirically investigates the importance of exchange rate and terms of trade movements as determinants of inflation rates across East Asian economies and discusses the role of central banks in guarding financial stability and the ways this may conflict with an IT regime. The article argues that IT never really has been a suitable monetary framework for East Asian countries and that it should hence be supplanted by transparent monetary frameworks that explicitly recognize the multiple goals that are being pursued by East Asian central banks.     

Optimal monetary policy regime for oil producing developing economies: Implications for post-war Iraq

This paper theoretically investigates optimal monetary policy regime for oil producing developing countries. We analyze credibility and reputation of the Central Bank and macroeconomic dynamics under alternative monetary policy regimes. We construct a detailed and realistic model that can be used to analyze macroecomic structure and expectation dynamics of an oil producing open economy. We take into account the asymmetric information between the public and the central bank and theoretically investigate how this asymmetric information impacts the real economy and the credibility of the central bank. The simulation results indicate that central bank achieves higher credibility and lower inflation under dollarization and higher output levels under currency board regime. The model constructed in this paper has many policy implications for oil producing open economies. Using the implications of the model, we make monetary policy regime recommendations for post-war Iraq.     

Learning process and rational expectations: An analysis using a small macro-economic model for New Zealand

The nature of expectations matters when conducting monetary policy. Models with a learning process can exhibit very different properties from models with other types of expectation rules. This paper draws on the work of Orphanides and Williams [Orphanides, A., Williams, J.C. 2002. Imperfect knowledge, inflation expectations and monetary policy, Federal Reserve Board Finance and Economics Discussion Series, 2002-27], extending it to allow for the possibility that the learning process may not be perpetual, but rather might be converging towards a rational expectations equilibrium. By modelling expectations using a learning process, we obtain that inflation expectations in New Zealand are moving towards rational expectations. The closer expectations are to rational, the more inflation can be reduced without costs, thus arguing for a rather tough policy aimed at anchoring expectations on the target.     

Signalling commitment with monetary and inflation targets

This article studies a two-period game between the public and a central bank about whose ability to commit to an announced target the public is uncertain. The central bank chooses between announcing a target for an intermediate variable (money growth) and its goal variable, inflation. Prior to setting its instrument, the central bank receives private, noisy information about the link between money growth and inflation. Monetary targeting facilitates communication of the central bank's type, in that the probability of separation is always higher than under inflation targeting. This advantage of monetary targets from a dependable central bank's perspective is outweighed for most parameter values by the advantage of inflation targeting in terms of inflation control. If the regime choice is treated as a strategic decision, over a large range of parameter values both central banks choose the regime that a dependable central bank would prefer.     

The exchange rate and optimal monetary policy rules in open and developing economies: Some simple analytics

Using a simple, tractable model, this paper revisits and expands upon issues relating to optimal monetary policy rules (MPRs) in open economies. The optimality of the rule is explored through various specifications of a central bank loss function as it is the loss function that offers insight into central bank preferences. Many of the issues on this topic have centred on the role of the exchange rate: Is it optimal for the policy instrument to react to the exchange rate? What is the role of the exchange rate in a domestic inflation targeting vs CPI inflation targeting? Does a fear of floating have any bearing on the way optimal MPRs are constructed? While this paper is not empirical, the analysis is relevant for central banks in open and developing economies that face a choice between allowing exchange rates to float (and adopting an inflation targeting regime) and engaging in some degree of exchange rate fixity.     

Inflation Targeting - the Holy Grail of Monetary Policy?

Inflation targeting is a statement about the objective of central bank policy and not about operating procedures. Its success depends not only on the actions of the central bank, but requires a broad consensus concerning the proper role of monetary policy in the economy. It also requires the backing of a sound fiscal policy. As countries differ both in economic structure and monetary transmission mechanism, the implementation of inflation targeting must be country specific. Instability over time in the transmission mechanism also implies that inflation targeting strategies must evolve to avoid the fate of previous monetary policy targeting practices.     

Fed speak on main street: Central bank communication and household expectations

Central banks emphasize the use of communication as a tool of monetary policy. As central banks increasingly recognize that low public informedness limits their ability to communicate with the general public, several have begun to explicitly tailor their communication strategies for a broader audience. Most research focuses on central bank communication with financial markets, but several recent strands of literature address aspects of communication with households. I survey the literature addressing the rationales and efficacy of central bank communication with households, supplementing this with new evidence from an assortment of consumer survey data. I draw from the literature on rational inattention, financial literacy, and political communication to suggest explanations for limited household receptiveness to central bank communications. Finally, I focus on one specific aim of central bank communication, which is to anchor inflation expectations. Previous literature finds that the announcement of an explicit inflation target helps anchor expectations among financial market participants. Using U.S. consumer survey data, I show that consumers’ expectations are imperfectly anchored and that the anchoring of more informed consumers’ expectations increased more than the anchoring of less informed consumers’ expectations following the Fed’s announcement of a 2% inflation target.     

Optimal price‐level drift under commitment in the canonical New Keynesian model

Abstract In both the canonical and many extended versions of the New Keynesian model, optimal monetary policy under commitment implies price‐level stationarity as long as expectations are rational. We show that this is no longer the case if the central bank and private agents make decisions before observing current shocks. The optimal amount of price‐level drift in response to unexpected innovations to inflation is quantitatively important. This result has important implications for monetary policy, including the design of the optimal loss function for the central bank if it cannot commit to its future policies.     

Fiscal limits and monetary policy: default vs. inflation

This paper studies the monetary policy trade-off between low inflation and low sovereign risk in the environment where fiscal authorities fail to fully ensure the sustainability of government debt. Building on the Fiscal Theory of Price Level (FTPL) and the Fiscal Theory of Sovereign Risk (FTSR), this paper differs in its baseline assumption about the monetary policy objective, which is neither to rule out defaults regardless of inflation costs (as in FTPL), nor to follow inflation targeting regardless of associated sovereign risk (as in FTSR). Instead, we study the case in which the central bank controls the risky interest rate to minimize the probability of default while ruling out large inflation hikes. We show that this policy regime can mitigate default risks only when the central bank is expected to allow sufficient increases in inflation. When agents believe that the central bank's tolerance toward inflation hikes has increased, equilibrium risk premium goes down, suggesting that information concerning changes in the central bank's preferences over inflation directly impacts default risks.