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Lecture 11 Inflation and monetary policy

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.

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Lecture 11 Inflation and monetary policy

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  1. Hubert Kempf Economic policies Master in economics Lecture 11 Inflation and monetary policy

  2. Inflation and monetary policy 1 – Inflation dynamics – recent trends and monetary policy strategy issues 2 – Inflation and monetary policy strategies: an overview

  3. 1 – Inflation dynamics 1.1 – Global trends 1.2 – Price developments in the euro area 1.3 – Monetary policy / strategy implications

  4. 1.1 – Recent trends: global disinflation

  5. 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

  6. 1.2 – Price developments in the euro area 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.

  7. HICP and core inflation

  8. Inflation persistence in the Euro Area – Macro evidence : Inflation de LT

  9. Price stickiness: micro data evidence Eurosystem Inflation Persistence Network - Analysis of CPI micro data - Analysis of producer prices - Survey evidence (à la Blinder, 1998) Based on “Price Setting in the euro area: Some stylised facts from Individual Consumer Price Data” by Dhyne, Álvarez, Le Bihan, Veronese, Dias, Hoffmann, Jonker, Lünnemann, Rumler and Vilmunen (2005)

  10. Raw data: (millions of) individual price recordsfrom 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

  11. 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)

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

  13. 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

  14. 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.

  15. 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%).

  16. Unprocessed food Processed food Energy Non-energy industrial goods Services Total Frequency of price changes 0.28 0.14 0.78 0.09 0.06 0.15 Frequency of price increases 0.15 0.07 0.42 0.04 0.04 0.08 Frequency of price decreases 0.13 0.06 0.36 0.03 0.01 0.06 Share of price increases 0.54 0.54 0.54 0.57 0.80 0.58 Frequency of price increases and price decreasesEuro area figures in p.c. (using HICP weights)

  17. Distribution of the frequency of price changes

  18. 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.

  19. Fact 6: Weak synchronisation of price changes across price-setters at the product level Note: Fisher and Konieczny. (2000) index FK=0 for perfect staggering and FK=1 for perfect synchronisation

  20. 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

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

  22. 1.3 - Monetary policy implications To recap : 1) Euro area has been hit by a series of cost-push 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

  23. Policy implications (1) 1) A smaller degree of inflation persistence implies a smaller response of policy rate to cost-push 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

  24. 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)

  25. 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

  26. 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

  27. 2.1- An overview of Monetary policy strategies 1 - Monetary policy framework Discretion Rule-based Currency Board Exchange Rate peg Crawling peg Inflation targeting Monetary targeting Multiple mandate 2 - communication Simple Complex

  28. 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 • monetary policy bound by a rule • simple and clear to communicate • can lower inflation quickly • …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

  29. 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

  30. 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

  31. 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

  32. 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!

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