INFLATION TARGETING AND NEW EU ENTRANTS: IS THERE MONETARY UNIFORMITY?

1. INFLATION TARGETING AND NEW EU ENTRANTS: IS THERE MONETARY UNIFORMITY? Joseph J. St. Marie The University of Southern Mississippi

2. ABSTRACT • The four newest entrants into the EU who have an explicit policy of inflation targeting for their respective central banks, is there policy uniformity within this group?  • Slovenia, Latvia, Lithuania, and Slovakia • This paper seeks to determine if there is a difference in interest rate targets between the high income (Slovenia) entrants and lower income entrants (Latvia, Lithuania, and Slovakia). The test instrument is the Taylor Rule.

3. INTRODUCTION • This paper explores inflation targeting in new European Unions members. • Monetary policy uniformity is one of the economic goals of the EU based upon the utility of price stability, for all members. • New members may or may not have policies that are in accordance with the European Central Bank. • This works analyzes new EU member monetary policy through the benchmark Taylor rule.

4. The Taylor Rule John Taylor presents a monetary policy rule that he characterizes as one, “that captures the spirit of the recent research and which is quite straightforward” (Taylor 1993). Thus we find the following formulation and coefficients. r=p+.5y + .5(p-2) + 2 where r= the federal funds rate, p= the rate of inflation over the previous four quarters y= the percent deviation of real GDP from a target. That is, y= 100(Y-Y*)/Y* where Y= real GDP, and Y*= is the trend real GDP

5. THE TAYLOR MODEL Taylor (1993) observed that the following equation provides a reasonable approximation for the short term funds rate for United States. r = p +.5 y +.5 (p-2) + 2 Where: r is the federal funds rate p is the rate of inflation over the previous quarters y is the percent deviation of real GDP from a target y = 100(Y-Y*)/Y* Y is the real GDP Y* is the GDP trend (Taylor 1993)

6. THE ARGUMENT • Given the evidence that the Taylor rule is a sufficient benchmark recommendation for Fed monetary policy we can assume that the rule will also be as useful if not more so when used as a benchmark recommendation for inflation targeting.

7. THE REFINED MODEL Other researchers have modified the model by tinkering with the calculations of inflation rate, interest rates, optimal output, targeted inflation rate, and the inflation and output gaps (Maria-Dolores 2005). Here the common practice of formulating Taylor rule models is followed ( Arestis & Chortareas 2006). rt = β0 + β1rt-1 + β2Inft + β3 OutputGapt + ε Where rt is the nominal interest rate Inft is the inflation rate in time t OUputGapt is the output gap In the above formulation the output gap is calculated according to Clarida, Gali & Gertler (1997), which is different from Maria-Dolores (2005). However, instead of using the regression trend line the Hodrick-Prescott filter is used. Since direct and reliable inflation rates are not available the CPI is used as the inflation measure (Clarida, Gali & Gertler 1997).

8. DATA Data for all countries span from 2001:1 to 2006:12. The Consumer Price Index is used for inflation, which is obtained from the sources, respectively. The industrial production index (IPI) is used to represent the output. The IPI are filtered through the Hodrick-Prescott procedure to obtain the potential output. The difference between the de-trended output and the IPI is used as the output gap.

9. RESULTS Table 1. Policy tools for inflation targeting, output targeting, and interest rate smoothing. T values are in parentheses. Levels of significant are * <.1, **<.05, ***<.01.

10. RESULTS • The inflation targeting coefficient is significant for Lithuania and Slovenia. • Only one of the significant variables is negative (Slovenia). Latvia does not have a significant output gap coefficient but has a highly significant coefficient for inflation, which indicates that it does target output. • Slovenia, is the only country for which both inflation and the output gap are significant, Slovenia thus does not necessarily support one tool or the other. • Overall, the evidence indicates that Lithuania is targeting inflation, while Latvia is targeting output. • The case of Slovenia is mixed as both coefficients are significant. Some researchers compare the magnitude of the coefficients to determine the orientation of policy. Based on this interpretation Slovenia becomes an output targeting nation.

11. RESULTS II • Only Slovakia has coefficients that are insignificant. • The coefficient for adjustment rate for the countries with a coefficient larger than one are very close to one (1) and the differences (all less than .026) is due to random error. • A similar argument applies to Latvia, whose value is just under one (1), albeit the gap is higher. Therefore, in Latvia the adjustments to interest rates are done instantaneously and without delay. • A common factor among all these countries is high values of the adjusted R-Squared.

12. CONCLUSIONS • Small open economies can target output as in the case of Latvia. • Slovenia seems to have a mixed targeting mechanism • A mixed mechanism would be indicative of the “two pillar” strategy used by the ECB to determine monetary policy. • Recently independent countries like Slovenia are using similar factors as developed nations to determine monetary policy.