On Inflation Targeting: Celebrating 1 Year of IT in Brazil

1. On Inflation Targeting:Celebrating 1 Year of IT in Brazil Klaus Schmidt-Hebbel Central Bank of Chile • Conference on “One Year of Inflation Targeting in Brazil” • Rio de Janeiro, July 10-11, 2000

2. Outline • (1) WHO DOES IT? • (2) IT IN TRANSITION TO LOW INFLATION • (3) HOW SUCCESSFUL HAS BEEN IT ? • (4) REMAINING OPEN ISSUES ABOUT IT • (5) CONCLUDING REMARKS • (6) REFERENCES

3. (1) WHO DOES IT?

6. IT Countries and Year of Adoption Source: Schaechter, Stone and Zelmer (2000)

7. Some countries with partial IT regime: • Colombia • Mexico • Peru • Some countries currently considering adoption of IT: • Japan • Thailand • Turkey

8. (2) IT IN TRANSITION TO LOW INFLATION

9. Inflation and Inflation Targets (Smoothened) in Chile Cumulative Jan. 1991- May 2000 Relative (Absolute) Deviation from Targets: 1.9%(3.9%)

12. Some Lessons from 1 Year of IT in Brazil • Brazil adopted IT under the most unfavorable initial conditions observed in any IT experience in the world - with outstanding results regarding inflation, growth, and external position • Adopting IT with most bells and whistles in place has paid off handsomely • Brazil confirms the paramount importance of correcting fiscal fundamentals and improving health of the banking system for IT to succeed - future persistence in both dimensions is needed • Brazil also shows that flexible exchange rates in open economies with low inflation exhibit small devaluation-to- inflation passthrough (confirming Goldfajn and Werlang 2000) • However Brazil’s experience also reflects the special tensions and issues confronted by ITers in transition to low inflation

13. Issues of IT in Transition to Low Inflation (I) • IT in transition to low inflation is very different from IT in • steady-state inflation: • Policy credibility is initially low – it is built up only by showing a good track record • Short (annual) target horizon makes it hard to achieve targets • Hence there is a bias toward overreacting to adverse shocks and to temporary shocks  inflation hawkishness and policy asymmetry • Ironically, the latter is needed to (over-) achieve targets in order to establish credibility

14. Issues of IT in Transition to Low Inflation (II) • Speed of adjustment (convergence period) to stationary inflation is dependent on credibility, inflation indexation mechanisms, inertia. • However, the decade-long Chilean and Israeli experiences of transition to low stationary inflation (and possibly the shorter Brazilian experience) suggest that the convergence period was excessively long, as ex post sacrifice ratios were likely lower than anticipated ex ante.

15. (3) HOW SUCCESFUL HAS BEEN IT?

16. Evidence from OECD Economies (Bernanke, Laubach, Mishkin, and Posen): 1. Does IT make disinflation less costly? No: sacrifice ratios and Phillips curves are not altered by IT 2. Does IT reduce inflation expectations? Not quickly, only gradually over time (consistent with 1) 3. Does IT reduce inflation? Yes: IT delivers lower long-run inflation than what would have been achieved in its absence. But IT is not a necessary condition for low long-term inflation.

17. Evidence from OECD and emerging economies (Cecchetti and Ehrmann) • Model: determines central bankers’ aversion to inflation variability from the sacrifice ratio (calculated from VAR impulse responses) and inflation and output variability • Full sample results for the inflation aversion coefficient (): • Average  for the sample of 9 ITers (including Chile and Israel) is 0.71-0.76, very close to: • Average  of control group of 14 non-ITers (including 2 emerging) is 0.73-0.74 • But: the ’s of ITers increase substantially either before or after starting IT (see figure)

19. (4) REMAINING OPEN ISSUES ABOUT IT

20. Design Issues • Operational (or instrument) independence alone? Yes, but ... • Which level of long-run inflation objective? Squeezed between Friedman, Keynes, and Harrod-Balassa-Samuelson .... • Point or Range Targets? No point will be met but any range is still too narrow ... • Targeting headline or core inflation? Credibility vs. relevance ... • Strict or relaxed accountability of Central Bank performance? Transparency, rules and discretion ... • Is IT with all bells and whistles a necessary or just a desirable prerequisite when starting IT? A lesson from Brazil ...

21. Research Issues • Observational equivalence between an explicit IT framework (say the UK) and other non-explicit monetary frameworks (say the U.S. or the Bundesbank before the Euro) or mixed regimes (Euroland) • Asymmetries and lags in inflationary effects of both shocks and monetary policy actions are not known with precision • Lack of agreement of optimal policy response to various types of shocks (nominal-real.financial, supply-demand, “permanent-transitory” - their difference not known ex ante) • Lack of understanding monetary transmission mechanisms and their empirical relevance is widespread

22. Monetary Policy Rule Inflation Expectations Market Rates /Term Structure Output Gap, Employment Projection of Core-Target Inflation Gap Monetary/Credit Aggregates Absorption- Income Gap (CA) Core Inflation Asset Prices (Wealth) Real Exchange Rate Nominal Exchange Rate T Inflation NT Inflation Monetary Transmission and Policy Rule in Open Economies Monetary Policy Rate

23. Model Development and Use • A necessary, continuous, and costly process  requires significant research capabilities • Chile’s case: current development of toolkit comprised by various (small) models used in explaining, forecasting, and simulating. They comprise: • Leading indicators of prices and activity • Small semi-structural VAR models (4 to 7 variables) • Flow-stock consistency model • Small backward-looking macro model for key relations and variables (inflation, Phillips curve, activity, absorption (or current account), potential output, imperfect interest parity, yield curve) • Micro-founded forward-looking rational expectations model for key relations and variables • Model development and use has been a learning process in emerging economies, at variable speed depending on needs and capabilities.

24. Conduct of Monetary Policy (I) • (problems also apply to other monetary frameworks) • Large gaps in above mentioned theoretical and empirical knowledge  monetary policy is conducted under high level of model and parameter uncertainty • Hence: is it feasible to forecast IT with a simple model? Yes, but development of a menu of increasingly complex models raises understanding and the level of policy discussion

25. Conduct of Monetary Policy (II) • Which weight should be attached to current variables (say inflation) as compared to predicted future variables? Answer often leads to symmetrical policy inertia • Which is the optimal speed and intensity of policy reaction to a given shock? Depends on various factors, including: uncertainty about shock feature, weight of arguments in objective function, degree of central bank aversion to frequent policy adjustments.

26. Conduct of Monetary Policy (III) • Which arguments should be included in the monetary policy rule? • 1. Inflation deviations only (”inflation nutter”) • 2. Inflation deviations plus output deviations (simple Taylor rule; possibly a majority of economists), but with a large weight attached to the former (“inflation hawks”) • 3. Inflation deviations plus output deviations plus exchange rate deviations (ECB?) or current-account deviations (some emerging economies CBs) • 4. Inflation deviations plus output deviations plus asset price deviations: • No: Bernanke and Woodford (1999) • Yes: Cecchetti et al. (2000)

27. (5) CONCLUDING REMARKS • 1. IT - combined with exchange-rate floating - seems to be the main alternative to dollarization or monetary union • 2. IT in transition is very different and, typically, more difficult than IT in steady-state low inflation • 3. Brazil’s IT experience is the boldest experience of adopting IT and, most likely, the world’s most successful one when controlling for initial conditions • 4. Yet a large number of issues on IT design and performance, and on the conduct of monetary policy under IT, have to be addressed to better understanding IT in the world, including: • the fine print on IT design and operation, • opening up the the black box of monetary transmission, and • deriving and defining more transparently an optimal policy rule.