Inflation Targeting Framework for Jamaica: An empirical exploration

1. Inflation Targeting Framework for Jamaica: An empirical exploration Bosede Nelson-Douglas Research & Economic Programming Division Bank of Jamaica The Role of Inflation Targeting, Federal Reserve Bank, Atlanta October 4-5, 2004

2. Presentation Outline • Brief Discussion on the conduct of Monetary policy in Jamaica • The Rational for Inflation Targeting for Jamaica • Brief Highlight on the Prerequisites for Inflation targeting • Testing the prerequisites of IT for Jamaica. • Survey approach to determine Bank of Jamaica’s independence • Test to determine level of seigniorage and Financial market depth in Jamaica • Issues of design and implementation of IT for Jamaica. • Definition of the price index, • Evaluation of the Monetary Control lags within the framework of a VAR model • Monte Carlo Simulation of how IT could work for Jamaica and the determination of the optimal inflation target horizon • Policy implications and recommendations

3. The Conduct of Monetary Policy in Jamaica • The challenges to Base money Management includes: • The Liberalization of the foreign exchange market in 1990 and capital account in 1991 • The Financial System crisis in 1997/1998 • The continued deterioration of the fiscal accounts and the heavy debt burden • The rapid financial innovation in the financial institutions • Adverse terms of trade and external shocks, particularly from oil prices and other commodity prices.

4. The Conduct of Monetary Policy in Jamaica

5. Rationale for IT as a framework for Monetary policy in Jamaica • The Weakening of the link between monetary aggregate and inflation due to financial innovations of the 1990s and other challenges to base money management • Monetary aggregates have not been able to provide an adequate signal about the stance of MP, which makes it difficult to serve as a communication device • Base money targeting has generally not been a good guide for assessing accountability of the central bank, particularly in light of the need for more credibility given the huge fiscal burden

6. Highlights of the fundamental Prerequisite for IT IT is defined as a monetary policy operating strategy that includes the following elements: • A commitment to price stability as the primary goal • Accountability of the central bank for attaining its monetary policy goal; • The public announcement of the inflation target • A policy for communicating to the public, the rationale for the decisions taken by the Bank • The ability to carry out an independent monetary policy • A quantitative framework linking monetary policy to inflation

7. Testing the Prerequisite of IT for Jamaica • Two major tests are conducted to determine the feasibility of IT for Jamaica • The First test involves a survey approach based on a set of indicators to test the degree of BOJ’s independence. The method involves • Classifying independence into political and economic independence, the former including 29 indicators and the latter, 7 indicators. • The indicators of political independence broadly includes the relationship between board members and the Governor at BOJ and the extent of Board members intervention in the decision making process

8. Comparative Results of CBI for Jamaica and France

9. CBI for Other Selected Countries

10. Testing the Prerequisite of IT for Jamaica,continued • The Second Major test involves the determination of the level of Seigniorage and financial market depth in Jamaica. • Seigniorage and 3 indicators of financial market depth was calculated, these include the average and standard deviation of the real interest rate on domestic deposits, and the average ratio of broad money to GDP • Heavy use of seigniorage is a common indicator of fiscal dominance, while positive real rates are a precondition for substantial financial deepening which enhances the financial intermediation process. The degree of monetisation is captured by the ratio of broad money/GDP

12. Issues of design and implementation Definition of the price index • Headline vs. core inflation • The BOJ in 1997 developed a measure of core inflation (the trimmed mean approach) which it publishes, along with headline inflation • For IT, the appropriate choice of the index is critical, and headline inflation rather than core may be advantageous, given the familiarity of this index to the public • Since CPI carries a heavy weight for volatile items such as food, the approach to determine which index to use entailed using a 3 variable VAR model of food prices, headline and core inflation to ascertain the effect of this volatility on inflation and how quickly these shocks dissipate.

13. Issues of design and implementation – Definition of the price index, contd

14. Issues of design and implementation – Monetary control lags, • To determine the monetary lags the paper uses a reduced-form VAR which provides the basis to stage a series of simulation that shows the potential effects of adopting IT in Jamaica • The variables in the VAR were guided by previous work done at the Bank. The data spans the period 1993:01 to 2003:12

15. Issues of design and implementation – Monetary control lags, • VAR Model Mt is the log of the growth rate in the value of imports Tbt is the log of 180-day Treasury bill rate Pt is the log of Consumer price index Bmt is the log of base money St is the log of the weighted average selling exchange rate Yt is the log of output gap using a Nelson-Beveridge decomposition of actual from Trend i are the shocks from the model C(L) are the lag polynomials

16. Issues of design and implementation – Monetary control lags, - impulse Response

17. Issues of design and implementation – Monetary control lags, - impulse Response

18. Issues of design and implementation – Monetary control lags, contd

19. Issues of design and implementation – Monetary control lags, contd

21. Monte Carlo simulation to determine how MP will evolve under an IT framework • The Setup for the Inflation targeting Regime for BOJ is as follows: • BOJ decides to adopt IT and meet monthly to update their inflation forecast from January 2001 to December 2003 • The inflation forecast is the intermediate target of monetary policy • The Inflation target is 5.0 percent • The Horizon is set between 12 and 24 months • The Inflation target band is 1.0 percentage points

22. Monte Carlo simulation to determine how MP will evolve under an IT framework • Assumptions are: • Equation 1 is a true representation of the Jamaican economy • The monetary transmission lags are stable • The simulation setup: • is derived from subjecting the model to both external and domestic shocks, which are drawn with equal probability from the reduced form model. These shocks are taken from relatively stable period and apply to all variables in the VAR • Based on shocks from the previous period, the BOJ updates its inflation forecast each month

23. IT simulation to determine the Inflation target horizon • The methodology Et{t+h} = e x [Bh x Et {t}] t = mt, Tbt, pt, bmt, st, yt, Bh = the coefficient associated with the hth lag The h-period ahead inflation forecast

24. IT simulation to determine the Inflation Target horizon • Monetary Policy Rule Is the inflation target is the contemporaneous money growth innovation . Is the width of the inflation target bank

26. IT simulation to determine the Inflation Target horizon • The Results show that : • a Lower volatility in macroeconomic variables is expected to occur over a shorter than a longer horizon • the Optimal forecast horizon lies between 12 and 18 months • Given the objective of stability, the fact that supply side shocks dissipate in one year and the monetary transmission mechanism is 85 percent complete at 12 months, this horizon seems to be the viable choice • An 18 months horizon is also a feasible alternative given the completion of the transmission process at this horizon • A 24-month horizon is totally ruled out as it render monetary policy ineffective

27. Conclusions and Policy Implications • IT represents a feasible alternative for the BOJ to achieve its objectives, but issues relating to the Fiscal burden and reform of the legal framework governing the BOJ remains a critical element • If IT is a desired alternative, the possible solution is to reform the legal framework to establish full autonomy of the bank or implement IT after sustained reduction in the fiscal deficit • Other conclusions from the paper includes • Headline inflation should be the index of choice under an IT regime • It takes 21 months for the transmission mechanism to be 100 percent complete • Given the relevance of a shorter horizon for IT, an 12 month Inflation target horizon is the preferred choice