This is not the document you are looking for? Use the search form below to find more!

Report home > World & Business

Inflation Targeting under Imperfect Knowledge

0.00 (0 votes)
Document Description
A central tenet of inflation targeting is that establishing and maintaining well-anchored inflation expectations are essential. In this paper, we reexamine the role of key elements of the inflation targeting framework towards this end, in the context of an economy where economic agents have an imperfect understanding of the macroeconomic landscape within which the public forms expectations and policymakers must formulate and implement mon- etarypolicy. Using an estimated model of the U.S. economy, we show that monetary policy rules that would perform well under the assumption of rational expectations can perform very poorly when we introduce imperfect knowledge. We then examine the performance of an easily implemented policy rule that incorporates three key characteristics of inflation targeting: transparency, commitment to maintaining price stability, and close monitoring of inflation expectations, and find that all three play an important role in assuring its success. Our analysis suggests that simpledierence rules in the spirit of Knut Wicksellexcelat tethering inflation expectations to the central bank's goal and in so doing achieve superior stabilization of inflation and economic activity in an environment of imperfect knowledge.
File Details
  • Added: April, 17th 2010
  • Reads: 159
  • Downloads: 4
  • File size: 389.28kb
  • Pages: 48
  • Tags: learning, natural rate of interest, natural rate of unemployment, rational expectations, monetary policy rules, uncertainty, bond prices
  • content preview
Submitter
  • Username: samanta
  • Name: samanta
  • Documents: 1258
Embed Code:

Add New Comment




Related Documents

Inflation Targeting at 20: Achievements and Challenges

by: samanta, 32 pages

This paper provides an overview of inflation targeting frameworks and macroeconomic performance under inflation targeting. Inflation targeting frameworks are generally quite similar across countries, ...

Inflation Targeting and Exchange Rate Rules in an Open Economy

by: samanta, 37 pages

This paper provides a simple dynamic neo-Keynesian model that can be used to analyze the impact of monetary policy that considers inflation targeting in a small open economy. This economy is ...

Inflation Targeting and Real Exchange Rates in Emerging Markets

by: samanta, 33 pages

We examine the inflation targeting (IT) experiences of emerging market economies, focusing especially on the roles of the real exchange rate and the distinction between commodity and non- commodity ...

Inflation Targeting and Target Instability

by: samanta, 57 pages

Monetary policy is modeled as being governed by a known rule, except for a time-varying target rate of inflation. The variable target is taken as representing either discretionary deviations from the ...

INFLATION TARGETING AND OUTPUT STABILISATION

by: samanta, 28 pages

Inflation targeting has been criticised for being 'inflation only' targeting and hence, for ignoring output and employment. This paper argues that this criticism is misplaced. The inflation-targeting ...

The Impact of Export State Trading Enterprises Under Imperfect Competition: The Small Country Case

by: shinta, 22 pages

There are two current major focal points of interest in state trading. At the broad level, there is much interest in the potential membership of countries like China and Russia in the World ...

The Performance of Forecast-Based Monetary Policy Rulesunder Model Uncertainty

by: samanta, 53 pages

In recent years, a number of researchers have advocated monetary policy rules for setting the short-term nominal interest rate rules in response to forecasts of inflation, rather than recent outcomes ...

THE NEW ECONOMY AND THE DOLLAR PUZZLE: THE CASE OF AUSTRALIA

by: samanta, 23 pages

The revolutionary changes in information technology (IT), globalisation and financial innovation have overturned the Solow productivity paradox and spawned a New Economy (NE) in Australia in the late ...

Monetary Policy, Deflation, and Economic History: Lessons for the Bank of Japan

by: samanta, 45 pages

The paper discusses Bank of Japan policy during the 1990s, especially the late 1990s, in the context of the historical experiences of the United States, Sweden, and Japan in the 1930s. Sharp ...

Open-Economy Inflation-Forecast Targeting

by: samanta, 33 pages

This paper extends previous research on simple inflation-forecast targeting by considering its effect in the open economy. It discusses the effect of the forecast-targeting horizon on interest rates ...

Content Preview
Finance and Economics Discussion Series
Divisions of Research & Statistics and Monetary Affairs
Federal Reserve Board, Washington, D.C.








Inflation Targeting under Imperfect Knowledge




















Athanasios Orphanides and John C. Williams
2006-20

NOTE: Staff working papers in the Finance and Economics Discussion Series (FEDS)
are preliminary materials circulated to stimulate discussion and critical comment. The
analysis and conclusions set forth are those of the authors and do not indicate
concurrence by other members of the research staff or the Board of Governors.
References in publications to the Finance and Economics Discussion Series (other than
acknowledgement) should be cleared with the author(s) to protect the tentative character
of these papers.

Inflation Targeting under Imperfect Knowledge∗
Athanasios Orphanides
Board of Governors of the Federal Reserve System
and
John C. Williams
Federal Reserve Bank of San Francisco
April 2006
Abstract
A central tenet of inflation targeting is that establishing and maintaining well-anchored
inflation expectations are essential. In this paper, we reexamine the role of key elements
of the inflation targeting framework towards this end, in the context of an economy where
economic agents have an imperfect understanding of the macroeconomic landscape within
which the public forms expectations and policymakers must formulate and implement mon-
etary policy. Using an estimated model of the U.S. economy, we show that monetary policy
rules that would perform well under the assumption of rational expectations can perform
very poorly when we introduce imperfect knowledge. We then examine the performance
of an easily implemented policy rule that incorporates three key characteristics of inflation
targeting: transparency, commitment to maintaining price stability, and close monitoring of
inflation expectations, and find that all three play an important role in assuring its success.
Our analysis suggests that simple difference rules in the spirit of Knut Wicksell excel at
tethering inflation expectations to the central bank’s goal and in so doing achieve superior
stabilization of inflation and economic activity in an environment of imperfect knowledge.
Keywords: Learning, Natural rate of interest, natural rate of unemployment, rational
expectations, monetary policy rules, uncertainty, bond prices.
JEL Classification: D83, D84, E52, E58.
∗We would like to thank Richard Dennis, Bill English, Ali Hakan Kara, Thomas Laubach, Nissan
Liviatan, John Murray, Rodrigo Vergara, and participants of presentations at the Federal Reserve
Board, the Bundesbank, the Federal Reserve Banks of Chicago and New York, the American Univer-
sity, the conference on “Monetary Policy under Inflation Targeting,” Santiago, October 20–21, 2005,
the conference in honor of Alex Cukierman on “New Developments in the Analysis of Monetary
Policy and Institutions,” Tel Aviv, December 15–16, 2005, and the British Columbia Macro/Bank
of Canada conference, Vancouver, April 7-8, 2006, for useful comments. The opinions expressed are
those of the authors and do not necessarily reflect the views of the Board of Governors of the Federal
Reserve System or the management of the Federal Reserve Bank of San Francisco.
Correspondence: Orphanides: Federal Reserve Board, Washington, D.C. 20551, Tel.: (202) 452-2654,
e-mail: Athanasios.Orphanides@frb.gov. Williams: Federal Reserve Bank of San Francisco, 101
Market Street, San Francisco, CA 94105, Tel.: (415) 974-2240, e-mail: John.C.Williams@sf.frb.org.

1
Introduction
A central tenet of inflation targeting is that establishing and maintaining well-anchored
inflation expectations are essential. Well-anchored expectations enables inflation-targeting
central banks to achieve greater stability of output and employment in the short-run, while
ensuring price stability in the long-run. Three elements of inflation targeting have been crit-
ically important for the successful implementation of this framework.1 First and foremost
is the announcement of an explicit quantitative inflation target and the acknowledgment
that low and stable inflation is the primary objective and responsibility of the central bank.
Second is the clear communication of the central bank’s policy strategy and the rationale
for its decisions, which enhances the predictability of the central bank’s actions and its
accountability to the public. Third is a forward-looking policy orientation, characterized by
the vigilant monitoring of inflation expectations at both short-term and longer-term hori-
zons. Together, these elements provide a focal point for inflation, facilitate the formation of
the public’s inflation expectations, and provide guidance as to actions that may be needed
to foster price stability.
Although inflation-targeting (IT) central banks have stressed these key elements, the
literature that has studied inflation targeting in the context of formal models has largely
described inflation targeting in terms of the solution to an optimization problem within the
confines of a linear rational expectations model. This approach is limited in its appreci-
ation of the special features of the inflation-targeting framework, as emphasized by Faust
and Henderson (2004), and strips from IT its raison d’ˆetre. In an environment of rational
expectations with perfect knowledge, for instance, inflation expectations are anchored as
long as policy satisfies a minimum test of stability. Furthermore, with the possible excep-
tion of a one-time statement of the central bank’s objectives, central bank communication
loses any independent role because the public already knows all it needs in order to form
expectations relevant for its decisions. In such an environment, the public’s expectations of
inflation and other variables are characterized by a linear combination of lags of observed
macroeconomic variables and, as such, they do not merit special monitoring by the central
1A number of studies have examined in detail the defining characteristics of inflation targeting. See
Leiderman and Svensson (1995), Bernanke and Mishkin (1997), Bernanke et al (1999), Goodfriend (2004),
and citations therein.
1

bank or provide useful information to the policymaker for guiding policy decisions.
In this paper, we argue that in order to understand the attraction of IT to central
bankers and its effectiveness relative to other monetary policy strategies, it is essential
to recognize economic agents’ imperfect understanding of the macroeconomic landscape
within which the public forms expectations and policymakers must formulate and implement
monetary policy. To this end, we consider two modest deviations from the perfect knowledge
rational expectations benchmark, and reexamine the role of the key elements of the inflation
targeting framework in the context of an economy with imperfect knowledge. We find
that including these modifications provides a rich framework in which to analyze inflation
targeting strategies and their implementation.
The first relaxation of perfect knowledge that we incorporate is to recognize that policy-
makers face uncertainty regarding the evolution of key natural rates. In the United States,
for example, estimates of the natural rates of interest and unemployment are remarkably
imprecise.2 Indeed, this problem is arguably even more dramatic for small open economies
and transitional economies that have tended to adopt IT. As is well known, policymaker
misperceptions regarding the evolution of natural rates can result in persistent policy errors,
hindering successful stabilization policy.3
The second modification that we allow for is the presence of imperfections in expecta-
tions formation that arise when economic agents have incomplete knowledge of the econ-
omy’s structure. We assume that agents rely on an adaptive learning technology to update
their beliefs and form expectations based on incoming data. Recent research has high-
lighted the ways in which imperfect knowledge can act as a propagation mechanism for
macroeconomic disturbances in terms of amplification and persistence that have first-order
implications for monetary policy.4 Agents may rely on a learning technology to guard
against numerous potential sources of uncertainty. One source could be the evolution of
natural rates in the economy, paralleling the uncertainty faced by policymakers. But an-
2For discussion and documentation of this imprecision see Orphanides and Williams (2002), Laubach and
Williams (2003), Clark and Kozicki (2005) and references therein. See also Orphanides and van Norden
(2002) for the related unreliability regarding the measurement of the natural rate of output and implied
output gap.
3For analyses of the implications of misperceptions for policy design see Orphanides and Williams (2002);
Orphanides (2003a); Cukierman and Lippi (2005); and references therein.
4See Orphanides and Williams (2004, 2005a,b,c); Gaspar and Smets (2002); Gaspar, Smets and Vestin
(2005); Milani 2005; and references in these papers.
2

other might be uncertainty regarding the policymaker’s understanding of the economy, and
likely response to economic developments, and perhaps the precise quantification of policy
objectives. Recognition of this latter element in the economy highlights a role for central
bank communications, including that of an explicit quantitative inflation target, that would
be absent in an environment of perfect knowledge.
We investigate the role of inflation targeting in an environment of imperfect knowledge
using an estimated quarterly model of the U.S. economy. Specifically, we compare the per-
formance of the economy subject to shocks with characteristics similar to those observed in
the data over the past four decades under alternative informational assumptions and policy
strategies. Following McCallum (1988) and Taylor (1993), we focus our attention on imple-
mentable policy rules that, nonetheless, capture the key characteristics of IT. Our analysis
shows that some monetary policy rules that would perform well under the assumption of
rational expectations with perfect knowledge can perform very poorly when we introduce
imperfect knowledge. In particular, rules that rely on estimates of natural rates for the set-
ting of policy are susceptible to making persistent errors. Under certain conditions, these
errors can give rise to endogenous “inflation scares” whereby inflation expectations become
unmoored from the central bank’s desired anchor. These results illustrate the potential
shortcomings of such standard policy rules and the desirability of identifying an alternative
monetary policy framework when knowledge is imperfect.
We then examine the performance of an easily implemented policy rule that incorporates
the three key characteristics of inflation targeting highlighted above in an economy with
imperfect knowledge, and find that all three play an important role in assuring its success.
First, central bank transparency, including explicit communication of the inflation target,
can lessen the burden placed on agents to infer central bank intentions and can thereby
improve macroeconomic performance. Second, policies that do not rely on estimates of nat-
ural rates are easier to communicate and better designed to ensuring medium-run inflation
control when natural rates are highly uncertain. Finally, policies that respond to the pub-
lic’s near-term inflation expectations help the central bank avoid falling “behind the curve”
in terms of controlling inflation, and result in better stabilization outcomes than policies
that rely only on past realizations of data and ignore information contained in private agent
expectations.
3

A reassuring aspect of our analysis is that despite the environment of imperfect knowl-
edge and the associated complexity of the economic environment, successful policy can be
remarkably simple to implement and communicate. We find that simple “difference” rules
that do not require any knowledge of the economy’s natural rates are particularly well suited
to assure medium-run inflation control when natural rates are highly uncertain. These rules
share commonalities with the simple robust strategy first proposed by Wicksell (1898), who,
after defining the natural rate of interest, also pointed out that precise knowledge about
it, though desirable, was neither feasible nor necessary for policy implementation aimed
towards maintaining price stability.
“This does not mean that the bank ought actually to ascertain the natural rate
before fixing their own rates of interest. That would, of course, be impractica-
ble, and would also be quite unnecessary. For the current level of commodity
prices provides a reliable test of the agreement or diversion of the two rates.
The procedure should rather be simply as follows: So long as prices remain
unchanged, the bank’s rate of interest is to remain unaltered. If prices rise, the
rate of interest is to be raised; and if prices fall, the rate of interest is to be
lowered; and the rate of interest is henceforth to be maintained at its new level
until a further movement in prices calls for a further change in one direction or
the other. ...
In my opinion, the main cause of the instability of prices resides in the instability
of the banks to follow this rule.”
Wicksell (1898, 1936), p. 189 (emphasis in original)
Our analysis confirms that simple difference rules that implicitly target the price level in
the spirit of Wicksell excel at tethering inflation expectations to the central bank’s goal and
in so doing achieve superior stabilization of inflation and economic activity.
The remainder of the paper is organized as follows. Section II describes the estimated
model of the economy. Section III lays out the model of perpetual learning and its cal-
ibration. Section IV analyzes key features of the model under rational expectations and
imperfect knowledge. Section V examines the performance of alternative monetary policy
strategies, including our implementation of inflation targeting. Section VI concludes.
4

2
A Simple Estimated Model of the U.S. Economy
We use a simple estimated quarterly model of the U.S. economy from Orphanides and
Williams (2002), the core of which consists of the following two equations:
πt = φππet+1 + (1 − φπ)πt−1 + απ(uet − u∗t) + eπ,t, eπ ∼ iid(0, σ2e ),
(1)
π
ut = φuuet+1 + χ1ut−1 + χ2ut−2 + χ3u∗t + αu (rat−1 − r∗t) + eu,t, eu ∼ iid(0, σ2e ).
(2)
u
Here π denotes the annualized percent change in the aggregate output price deflator, u
denotes the unemployment rate, u∗ denotes the (true) natural rate of unemployment, ra
denotes the (ex ante) real interest rate with one year maturity, and r∗ the (true) natural
real rate of interest. The superscript e denotes the public’s expectations formed during
t − 1. This model combines forward-looking elements of the New Synthesis model studied
by Goodfriend and King (1997), Rotemberg and Woodford (1999), Clarida, Gal´ı and Gertler
(1999), and McCallum and Nelson (1999), with intrinsic inflation and unemployment inertia
as in Fuhrer and Moore (1995a), Batini and Haldane (1999), Smets (2003), and Woodford
(2003).
The “Phillips curve” in this model (1) relates inflation during quarter t to lagged in-
flation, expected future inflation, and expectations of the unemployment gap during the
quarter, using retrospective estimates of the natural rate discussed below. The estimated
parameter φπ measures the importance of expected inflation for the determination of in-
flation. The unemployment equation (2) relates unemployment during quarter t to the
expected future unemployment rate, two lags of the unemployment rate, the natural rate
of unemployment, and the lagged real interest rate gap. Here, two elements importantly
reflect forward-looking behavior. The first element is the estimated parameter φu, which
measures the importance of expected unemployment, and the second is the duration of the
real interest rate, which serves as a summary of the influence of interest rates of various
maturities on economic activity. We restrict the coefficient χ3 to equal 1 − φu − χ1 − χ2 so
that the equation can be equivalently written in terms of the unemployment gap.
In estimating this model, we are confronted with the difficulty that expected inflation
and unemployment are not directly observed. Instrumental variable and full-information
maximum likelihood methods impose the restriction that the behavior of monetary policy
5

and the formation of expectations be constant over time, neither of which appears tenable
over the sample period that we consider (1969–2002). Instead, we follow the approach
of Roberts (1997) and use survey data as proxies for expectations. (See also Rudebusch
(2002) and Orphanides and Williams (2005b).) In particular, we use the median forecasts
from the Survey of Professional Forecasters from the prior quarter as the expectations
relevant for the determination of inflation and unemployment in period t; that is, we assume
expectations are based on information available at time t − 1. In addition, to match the
inflation and unemployment data as well as possible with the forecasts, we employ first-
announced estimates of these series in our estimation. Our primary sources for these data
are the Real-Time Dataset for Macroeconomists and the Survey of Professional Forecasters,
both currently maintained by the Federal Reserve Bank of Philadelphia (Zarnowitz and
Braun (1993), Croushore (1993), and Croushore and Stark (2001)). Using least squares
over the sample 1969:1 to 2002:2, we obtain the following estimates:
πt = 0.540 πet+1 +0.460 πt−1 − 0.341 (uet − u∗t) + eπ,t,
(3)
(0.086)
(−−)
(0.099)
SER = 1.38, DW = 2.09,
ut = 0.257 uet+1 + 1.170 ut−1 − 0.459 ut−2 − 0.032 u∗t + 0.043 (rat−1 − r∗t) + eu,t, (4)
(0.084)
(0.107)
(0.071)
(−−)
(0.013)
SER = 0.30, DW = 2.08,
The numbers in parentheses are the estimated standard errors of the corresponding re-
gression coefficients. (Dashes are shown under the restricted parameters.) The estimated
unemployment equation also includes a constant term (not shown) that captures the aver-
age premium of the one-year Treasury bill rate we use for estimation over the average of the
federal funds rate, which corresponds to the natural rate of interest estimates we employ in
the model. For simplicity, we make no attempt to model the evolution of risk premia. In
the model simulations, we impose the expectations theory of the term structure whereby
the one-year rate equals the expected average of the federal funds rate over four quarters.
6

2.1
Natural Rates
We assume that the true processes governing natural rates in the economy follow highly
persistent autoregressions. Specifically, we posit that the natural rates follow:
u∗t = 0.01¯u∗ + 0.99 u∗t−1 + eu∗,t,
r∗t = 0.01¯r∗ + 0.99 r∗t−1 + er∗,t,
where ¯
u∗ and ¯
r∗ denote the unconditional means of the natural rates of unemployment and
interest, respectively. The assumption that these processes are stationary is justified by the
finding based on a standard ADF test that one can reject the null of nonstationarity of
both the unemployment rate and the ex post real federal funds rate over 1950–2003 at the
5 percent level. To capture the assumed high persistence of these series, we set the AR(1)
coefficient to 0.99 and and then calibrate the innovation variances to be consistent with
estimates of time variation in the natural rates in postwar U.S. data.
As discussed in Orphanides and Williams (2002), there exists a wide range of estimates
of the variances of the innovations to the natural rates. Indeed, owing to the imprecision in
estimates of these variances, the postwar U.S. data do not provide clear guidance regarding
these parameters. Therefore, we consider three alternative calibrations of these variances,
which we index by s. The case of s = 0 corresponds to constant and known natural rates,
where σe
= σ
= 0. For the case of s = 1, we assume σ
= 0.070 and σ
= 0.085.
u∗
er∗
eu∗
er∗
These values imply an unconditional standard deviation of the natural rate of unemployment
(interest) of 0.50 (0.60), in the low end of the range of standard deviations of smoothed
estimates of these natural rates suggested by various estimation methods (see Orphanides
and Williams 2002 for details). Finally, the case of s = 2 corresponds to the high end of
the range of estimates, for which case we assume σe
= 0.140 and σ
= 0.170. Arguably,
u∗
er∗
given the stability of the post-war U.S. economy relative to many small open economies
and transitional economies, for those countries the relevant values of s may be higher than
those based on U.S. data.
2.2
Monetary Policy
We consider two classes of simple monetary policy rules. First, we analyze versions of the
“Taylor Rule” (Taylor 1993), where the level of the nominal interest rate is determined by
7

the perceived natural rate of interest, ˆ
r∗t, the inflation rate, and a measure of the level of
the perceived unemployment gap, the difference between the unemployment rate and the
perceived natural rate of unemployment, ˆ
u∗t,
it = ˆr∗t + ¯πet+j + θπ(¯πet+j − π∗) + θu(uet+k − ˆu∗t),
(5)
where ¯
π denotes the four-quarter average of the inflation rate, π∗ is the central bank’s
inflation objective, j is the forecast horizon of inflation, and k is the forecast horizon of
the unemployment rate forecast. We consider a range of values for the forecast horizons
from −1, in which case policy responds to the latest observed data (for quarter t − 1), to
a forecast horizon up to three years into the future. When policy is based on forecasts, we
assume that the central bank uses the same forecasts of inflation and unemployment rate
as available to private agents.
We refer to this class of rules as “level rules” because they relate the level of the interest
rate to the level of the unemployment gap. Rules of this type have been found to perform
quite well in terms of stabilizing economic fluctuations, at least when the natural rates of
interest and unemployment are accurately measured. Note that here we consider a variant
of the Taylor rule that responds to the unemployment gap instead of the output gap for our
analysis, recognizing that the two are related by Okun’s (1962) law. In his 1993 exposition,
Taylor examined response parameters equal to 1/2 for the inflation gap and the output gap,
which, using an Okun’s coefficient of 2, corresponds to setting θπ = 0.5 and θu = −1.0.
If policy follows a level rule given by equation (5), then the “policy error” introduced
in period t by natural rate misperceptions is given by

r∗t − r∗t) − θu(ˆu∗t − u∗t).
Although unintentional, these errors could subsequently induce undesirable fluctuations
in the economy, worsening stabilization performance. The extent to which misperceptions
regarding the natural rates translate into policy induced fluctuations depends on the param-
eters of the policy rule. As is evident from the expression above, policies that are relatively
unresponsive to real-time assessments of the unemployment gap, that is, those with small
θu, minimize the impact of misperceptions regarding the natural rate of unemployment.
As discussed in Orphanides and Williams (2002), one policy rule that is immune to
natural rate mismeasurement of the kind considered here is a “difference” rule where the
8

Document Outline

  • 0620out.pdf

Download
Inflation Targeting under Imperfect Knowledge

 

 

Your download will begin in a moment.
If it doesn't, click here to try again.

Share Inflation Targeting under Imperfect Knowledge to:

Insert your wordpress URL:

example:

http://myblog.wordpress.com/
or
http://myblog.com/

Share Inflation Targeting under Imperfect Knowledge as:

From:

To:

Share Inflation Targeting under Imperfect Knowledge.

Enter two words as shown below. If you cannot read the words, click the refresh icon.

loading

Share Inflation Targeting under Imperfect Knowledge as:

Copy html code above and paste to your web page.

loading